securitization of car financing assets: a capital raising...

100
Securitization of car financing assets: A capital raising strategy Vincent Bakker Master Thesis commissioned by: Bovemij Financieringsmaatschappij & University of Twente Publication date: 21-03-2014 PUBLIC VERSION

Upload: others

Post on 26-Jun-2020

1 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

Securitization of car financing assets: A capital raising strategy

Vincent Bakker

Master Thesis commissioned by:

Bovemij Financieringsmaatschappij

&

University of Twente

Publication date: 21-03-2014

PUBLIC VERSION

Page 2: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

i Master Thesis Vincent Bakker 21-03-2014

Securitization of car financing assets:

A capital raising strategy

Author:

V. (Vincent) Bakker

Industrial Engineering & Management

Specialization: Financial Engineering & Management

Supervisors:

University of Twente

Ir. H. (Henk) Kroon

University of Twente

Dr. B. (Berend) Roorda

Bovemij Verzekeringsgroep

J. (Jan) van der Vlist

Page 3: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

ii Master Thesis Vincent Bakker 21-03-2014

Preface This thesis is written as the final examination of my master study Financial Engineering &

Management. In the summer of 2013 I got a great offer to perform my internship at the Bovemij

Financieringsmaatschappij, with a study to securitization funding solutions.

I have experienced the topic of securitization as a very complex but fascinating field of structured

finance. It turned out to be a very challenging research project, due to the complexity of securitization

transactions. However, I have always had confidence in a good outcome. Besides that, I have gained a

lot of knowledge and experience about the exact working of a finance company. I got several

possibilities to attend discussions and calls with third parties about the topic of securitization. It has

been a valuable learning period as a complement to my study.

I would like to thank my colleagues for their openness, friendliness and social interaction. In

particular, I would like to thank my supervisor and sparring partner Jan van der Vlist for his guidance

and pleasant collaboration. His knowledge and experience in the field of car related financings made

sure that I got the necessary quality input for my research. In addition, our discussions and (critical)

feedback sessions were very helpful to improve the quality of my research.

Besides that, I would like to thank Henk Kroon for his role as an exam supervisor. In our periodic

discussions, he explained his critical view on the contents. His advice have put me in the right

direction and improved the end result of this research. Moreover, his structural recommendations have

ensured that the report is properly structured. I also want to thank Berend Roorda for his critical view

and advice on the content and structure of the research.

Above all, I wish to thank my parents for their support during my study. Thanks to their support, I was

able to successfully complete my master‟s degree.

I wish you pleasant reading!

Vincent Bakker

Page 4: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

iii Master Thesis Vincent Bakker 21-03-2014

Management summary This study provides insight in the possibilities of performing an asset-backed securitization program as

a funding solution for the Bovemij Financieringsmaatschappij (BFM) and gives advice on the steps to

be taken in order to facilitate a securitization funding strategy. Securitization is a structured finance

solution that has the potential to raise cost-effective capital from capital markets by selling securities

that are backed by a portfolio of cash flow generating assets.

The way of thinking of end customers is undergoing a change from owning a car towards using a car.

They are getting more cost conscious and interested in a full service product in which they finance

their car with additional services, such as maintenance, insurance and a guaranteed residual value for a

fixed amount per period. However, most of the BOVAG enterprises are unable to offer a (profitable)

full service product, due to high costs of funding, managing and controlling their car financing

operations. They are not able to come along with the changing market and they may lose a part of the

customer base or market share that shifts to a full service product. This results in a deteriorating

position of the BOVAG enterprises in the car sales chain.

Outsourcing the management and funding of lease activities to C4L and BFM enables the leasing

department or company of BOVAG enterprises to offer (profitable) full service products and anticipate

on the changing mind-set of end customers. This enables BOVAG enterprises to strengthen or regain

their position in the car sales chain. However, potential capital shortage could possibly limit the

growth of the car financing asset portfolio of the finance company in the foreseeable future, whereby

the funding support to BOVAG enterprises cannot be extended. Our objective was to (i) investigate

how the securitization of car financing contracts can be organized as a funding strategy in order to

raise capital in a cost-effective way and (ii) determine what adjustments need to be made to facilitate

the introduction of securitization as a funding strategy. This would help to ensure the continuous

growth of the asset portfolio.

Initially, we focused on self-contained securitization programs (master trust, owner trust and grantor

trust securitization structures), in which capital is raised from capital markets solely based on the asset

portfolio of the finance company. However, participating in a multi-seller asset-backed commercial

paper securitization (ABCP) of a large bank turns out to be more interesting in the foreseeable future.

We have developed an assessment model in which we formulated three criteria to weigh different

securitization structures against each other. Based on the flexibility, certainty and the cost-effective

deal size of the structures, we have determined which structure is most suitable for the finance

company.

The research shows that participating in a multi-seller ABCP securitization structure is the only cost-

effective securitization funding strategy for BFM. Currently, the high additional costs of securitization

cannot be offset by the relative small asset portfolio volume of BFM. As the portfolio grows towards

the capital capacity of 100 million, it becomes interesting to introduce a securitization transaction.

This is expected to be at the end of 2015 or begin of 2016. Self-contained structures are less

interesting based on their large cost-effective deal sizes. Nevertheless, they may provide a more secure

and stable funding solution. If the portfolio grows to a larger volume than currently is foreseen, these

structures can also provide a good outcome.

The precise cost-effectiveness of a securitization program is depending on a number of (key) rating

drivers that influence the quality and risks of a securitization transaction. Credit risk and residual value

risk turned out to be the most decisive key rating drivers in car financing securitization transaction. To

increase the quality of the potential securitization transaction, we have established a framework of the

Confidential

Confidential

Page 5: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

iv Master Thesis Vincent Bakker 21-03-2014

key rating drivers to get grip on the rating and pricing process of the potential securitization

transaction. This framework enables us to quantify and control the indicators of influencing factors

that are used by rating agencies to estimate the variables that determine the level of credit risk and

residual value risk.

The initial assessment of the creditworthiness of the securitization transaction will be largely based on

the supplied historical portfolio performance data of at least 3 to 5 years and portfolio characteristics

data. A compelling recommendation is to improve the data process and control on (historical) payment

behaviour of customers & end customers and portfolio characteristics. We advise to start keeping

record of historical performance data and portfolio data on two layers (customers and end

customers).This facilitates not only a potential future securitization transaction, but also provides more

insight in the portfolio characteristics and performance. During the actual creation of the transaction,

credit enhancement methods can be used to increase the creditworthiness of the securitization.

We recommend to improve (operational) business processes to facilitate a securitization funding

strategy. Rating agencies require to receive a clear description of the origination, underwriting and

servicing process, and capabilities of the finance company. In order to be well prepared for a

securitization transaction, we advise to define and control the business processes, obligor profiles and

collateral quality. We advise to use standardized processes as much as possible, to reduce the

complexity of a potential securitization transaction.

The exact determination of the costs involved in multi-seller ABCP is hard to determine in this early

pre-securitization stage, particularly through the reluctant attitude of ABCP sponsors. We recommend

to choose an ABCP sponsor partner to obtain more insight in costs and gains of the potential

securitization funding strategy.

The capital limit ensures that participating in a multi-seller ABCP is the first step to organize the

securitization of the asset portfolio of BFM. However, the portfolio must grow to a larger volume in

order to securitization as a cost-effective funding strategy. The step to a cost-effective self-contained

securitization program is not possible without the intermediate step of participating in a multi-seller

asset-backed commercial paper (ABCP) conduit.

Confidential

Page 6: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

v Master Thesis Vincent Bakker 21-03-2014

Table of contents Preface ..................................................................................................................................................... ii

Management summary ........................................................................................................................... iii

List of abbreviations .............................................................................................................................. vii

Chapter 1: Introduction ........................................................................................................................... 1

1.1 Background & relevance ............................................................................................................... 1

1.2 Research objective & problem statement ...................................................................................... 6

1.3 Methodology & approach .............................................................................................................. 8

1.4 Report structure ............................................................................................................................. 9

Chapter 2: Securitization ....................................................................................................................... 11

2.1 Definition of securitization .......................................................................................................... 11

2.2 Motivation for securitization ....................................................................................................... 12

2.3 Process of securitization .............................................................................................................. 14

2.4 Special purpose vehicle (SPV) .................................................................................................... 19

2.5 Credit rating ................................................................................................................................. 20

2.6 Credit enhancement ..................................................................................................................... 21

2.7 Conclusion ................................................................................................................................... 25

Chapter 3: Asset portfolio identification ............................................................................................... 27

3.1 Financial asset types .................................................................................................................... 27

3.2 Current portfolio .......................................................................................................................... 29

3.3 Portfolio development ................................................................................................................. 31

3.4 True sale & titling transfer .......................................................................................................... 33

3.5 Conclusion ................................................................................................................................... 34

Chapter 4: Securitization structure decision .......................................................................................... 36

4.1 Master trust structure ................................................................................................................... 36

4.2 Grantor & owner trust structure .................................................................................................. 38

4.3 Asset-backed commercial paper (conduit) .................................................................................. 39

4.4 Assessment model for structure decision .................................................................................... 44

4.5 Estimation of cost-effective deal size for BFM ........................................................................... 49

4.6 Conclusion ................................................................................................................................... 53

Chapter 5: Key rating drivers ................................................................................................................ 56

5.1 Credit risk .................................................................................................................................... 56

5.2 Residual value risk ...................................................................................................................... 58

5.3 Control of rating drivers .............................................................................................................. 60

5.4 Historical portfolio performance data ......................................................................................... 61

5.5 Influencing factors & indicators .................................................................................................. 63

Page 7: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

vi Master Thesis Vincent Bakker 21-03-2014

5.6 Other rating drivers ..................................................................................................................... 67

5.7 Conclusion ................................................................................................................................... 71

Chapter 6: Conclusion, recommendations & discussion ....................................................................... 74

6.1 Conclusion ................................................................................................................................... 74

6.2 Recommendations ....................................................................................................................... 77

6.3 Discussion ................................................................................................................................... 79

Reference list ......................................................................................................................................... 80

Appendices ............................................................................................................................................ 85

Appendix 1: Simplified organization structure ................................................................................. 85

Appendix 2: Different lease types ..................................................................................................... 85

Appendix 3: Funding and portfolio ................................................................................................... 86

Appendix 4: Synthetic securitization................................................................................................. 86

Appendix 5: Credit ratings by different rating agencies .................................................................... 87

Appendix 6: Calculation of portfolio growth .................................................................................... 87

Appendix 7: Revenue model of BFM ............................................................................................... 88

Appendix 8: Cost estimation ............................................................................................................. 90

Appendix 9: Explanation of Excel model of cost-effective deal size ................................................ 91

Page 8: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

vii Master Thesis Vincent Bakker 21-03-2014

List of abbreviations ABCP = Asset-Backed Commercial Paper

ABS = Asset-Backed Security

BF = Bovemij Finance

BFD = Bovemij Financiële Diensten

BFM = Bovemij Financieringsmaatschappij

BVG = Bovemij Verzekeringsgroep

C4L = Care4Lease

CDO = Collateralized Debt Obligation

CMBS = Commercial Mortgage Backed Security

CP = Commercial Paper

EAD = Exposure At Default

EBIT = Earnings Before Interest and Tax

LGD = Loss Given Default

MBS = Mortgage Backed Security

PD = Probability of Default

RMBS = Residential Mortgage Backed Security

SCR = Solvency Capital Requirements

SPV = Special Purpose Vehicle

SMB = Schadeverzekering-Maatschappij Bovemij

SUBI = Special Unit of Beneficial Interest

UTI = Undivided Trust Interest

WACC = Weighted Average Cost of Capital

Page 9: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

1 Master Thesis Vincent Bakker 21-03-2014

Chapter 1: Introduction In the recent years it has become more difficult to obtain external funding. Influenced by the crisis,

new regulatory framework (Basel III and Solvency II) and fragile economic recovery, banks have

become more cautious with providing loans to enterprises and private individuals. Small and medium

sized enterprises in various sectors are often highly dependent on traditional bank funding in order to

obtain external funding. They are unable to acquire capital directly from the financial capital markets,

because of their financial status, credit rating, (small) size and lack of knowledge of capital markets.

The mobility sector in the Netherlands is also affected by the fact that banks have become more

careful with providing loans. A large number of enterprises within the mobility sector do not have the

power or the ability to achieve cost-effective funding on its own, making it difficult to have sufficient

working capital.

This thesis is commissioned by the Bovemij Financieringsmaatschappij which is a new business unit

of the Bovemij Verzekeringsgroep. Bovemij Financieringsmaatschappij is a fast growing finance

company that has been launched to support enterprises and their customers, within the mobility sector,

by providing financings against better rates than they can achieve via traditional bank funding or other

financial sources. The new business unit is currently financed with equity, debt from the group and

debt from a third party, but this funding is limited to a certain height. The growing portfolio of

financings can possibly lead to capital shortage in the foreseeable future. Therefore, it is already of

importance to find a suitable funding solution and determine a funding strategy in order to ensure the

continuity of the finance company.

One of the considered options is conducting a securitization program. In the current market conditions,

securitization is one of the few structured finance solutions that has the potential to raise cost-effective

capital from capital markets by selling securities that are backed by cash flow generating assets. This

research should clarify how capital can be raised through a complex branch specific securitization

funding strategy, in which an asset portfolio of lease contracts may be securitized, with a car as

collateral. The purpose of the first chapter is to introduce the relevance and background of the research

topic. Furthermore, we explain the design and structure of the study. In Section 1.1, we outline the

background and relevance behind this research. The section should be read as an introduction to

understand the underlying idea of the research topic. In Section 1.2, we explain the objective, sub

goals and problem statement of the research. In Section 1.3, we explain the methodology and approach

that are used to accomplish the objective of this research. We address the research questions that are

used to solve the central research question and explain the methods for gathering information and data

that are used for solving research questions. In Section 1.4, we explain the structure of the research.

1.1 Background & relevance The Bovemij Verzekeringsgroep (BVG) is a medium sized insurance company which is established

and partly owned by the BOVAG1. Their financial services are focussed on the mobility sector in the

Netherlands, by offering an extensive package of insurances, existing of business insurance, employee

insurance and consumer insurance, to particularly BOVAG affiliated enterprises and their employees

and customers. The BVG supports customers in the mobility sector in obtaining financings via two

business units, Bovemij Financiële Diensten (BFD) and Bovemij Finance (BF). These units act as an

intermediary between lenders and end customers in order to arrange financial products (funding and

1 BOVAG is an inter-branch organisation of (±11.000) members in the mobility sector. It is established for

common interests within the mobility sector. The BOVAG is 83% owner of the Bovemij Verzekeringsgroep.

Page 10: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

2 Master Thesis Vincent Bakker 21-03-2014

insurance) between both parties, whereby they receive commissions from lenders. They operate out of

the BOVAG enterprises.

Influenced by deteriorating financial markets and developments in the mobility sector, the BVG has

decided to start a new business unit; Bovemij Financieringsmaatschappij (BFM)2. The objective of

BFM is to support enterprises and their customers, within the mobility sector, by providing financings

against better rates than they can achieve via traditional bank funding or other financial sources in

order to increase the efficiency of enterprises. The new business unit is initially focussing on a

particular part of the mobility branch. They have started to support car dealer and universal companies

with their financing, management and administration of car financing products, with emphasis on

lease related products.

In the Netherlands, many private and business cars are purchased with some form of financing. Figure

1 show how the total number of passenger cars is divided among private and corporate customers in

the Netherlands. According to the VNA (2012)3, the current passenger car fleet in the Netherlands

exists of about 7,8 million cars. In addition, there are 851.000 commercial light vehicles. The

passenger car market is distinguished in (6,9 million) private and (0,898 million) company cars, from

which a part of the private cars is used for business purposes. About 326.000 private cars are used over

50% for business purposes. The other part (6,6 million) is less than 50% used for business purposes.

Many of these private vehicles are purchased with some form of financing. They are financed through

financial products such as personal loans, auto loans and revolving credit.

Figure 1: Private and corporate passenger car fleet distribution in the Netherlands in 2012 (VNA, 2012)4

The current business of BFM is focused on providing financings to car dealer and universal enterprises

that are mainly used for operational lease purposes to business end customers. According to VNA

(2012), the current business car market exists of 898.000 passenger cars and 851.000 light commercial

vehicles, from which 557.000 passenger cars and 136.160 light commercial vehicles are registered as

leased vehicles. The distribution between various types of lease is displayed in Table 1. These figures

display that most part of the lease market is allocated to operational lease. On the one hand, there is an

increase in the quantities of net operational lease and financial lease contracts. On the other hand, there

is a decrease in the number of open end operational lease contracts. Other shifts are negligible low.

2 For more details on the organisation structure we refer to Appendix 1.

3 Vereniging van Nederlandse Autoleasemaatschappijen is an inter-branche organisation of leasing companies.

4 The light commercial vehicle market is not included in the picture and exists of 851.000 vehicles. The research

of VNA did not address the amount or percentage of other financings, such as car loans.

Page 11: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

3 Master Thesis Vincent Bakker 21-03-2014

Table 1: Dutch business lease contracts (in numbers) in the Netherlands, 2012 and 20115

The usual car sales chain, as displayed in Figure 2, is as follows: Manufacturer Importer

BOVAG-enterprise (car company) Business or private customers.

Figure 2: The car sales and car financing market chain

In many cases, customers will close a financial agreement (in the form of loans, lease and hire), in

order to pay or finance the car. Generally, there are 3 possibilities: (i) the end customer arranges a

financing on its own (for example with an ordinary bank loan or his private savings); (ii) the end

customer arranges a financing with the car company (especially at leasing companies); (iii) the end

customers arranges a financing with a third party via the car company. In the latter case (as displayed

in Figure 2), the financing is typically arranged with the intervention of an intermediary, which acts as

a middleman or intermediary between lenders and end customers. Such lenders are ordinary banks,

captives (bank subsidiaries of major vehicle manufacturers and importers) and independent leasing

companies. BVG (with BFD and BF) is acting as an intermediary between lenders and end customers

through the BOVAG enterprises with the objective to arrange financing between both parties

5 Figures are based on the VNA affiliated members only. They represent about 90% of the total lease market. For

a reminder of the differences between the lease contract types, we refer to Appendix 2.

passanger car Light comercial vehicle

Dutch lease contracts 2012 2011 shifts 2012 2011 shifts

Operational lease closed end 387.400 375.600 3,2% 72.800 74.700 -1,7%

Operational lease open end 48.000 54.600 -12,1% 12.100 13.000 -1,6%

Financial lease 33.200 30.700 8,0% 21.800 21.300 2,6%

Car fleet 25.200 25.500 -1,4% 11.100 11.700 -3,7%

Net operational lease 13.900 12.300 12,5% 4.300 4.500 2,3%

Total 507.800 498.800 1,8% 122.200 125.100 -4,7%

Page 12: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

4 Master Thesis Vincent Bakker 21-03-2014

(displayed in Figure 2). They operate from the point of sale at BOVAG members and use their

collaborations with (ordinary) banks and captives in order to be intermediary in finance and insurance

for customers. Thereby, they receive a provision from their lending partner.

A number of factors ensure that the strength of the collective of BOVAG affiliated enterprises is

shifting away towards the major independent manufactures/ importers and their banks/ captives. The

way of thinking of end customers is undergoing a change from owning a car towards using a car.

Figure 3 shows the development of the car passenger lease market in the Netherlands6. After the crisis

dip in 2009 and 2010, the number of passenger car leases has continued the upward trend as before the

crisis. In addition, current developments show that there is an increasing demand for private lease

constructions and lease products under the business market7. Customers are getting more cost

conscious and interested in a full service product in which they finance their car with additional

services, such as maintenance, insurance and a guaranteed residual value for a fixed amount per

period8. Depending on the agreements, they know in advance what they can expect in terms of

payments and services. Additional for business, this can ensure favourable accounting benefits. By

financing cars instead of buying cars, it is possible for enterprises to keep scarce capital available for

core businesses.

Figure 3: Development of passenger car leases in the Dutch market from 2003-2012 (VNA, 2012).

Most BOVAG enterprises that operate or wishes to operate in the car financing market are not wealthy

enough or unable to obtain (cost-effective) funding through traditional bank funding on their own.

They may not possess sufficient working capital. Above that, the costs of funding, managing and

controlling their financing operations are often too high to operate in a profitable way. Consequently,

most of the BOVAG enterprises are unable to offer a (profitable) full service product. On the other

hand, the majority of banks and captives are (partly) owned by manufacturers or importers, which

enables them to deliver the car and operate as a lender through their own banks and captives.

Moreover, there is a development going on in which manufactures (and importers) and their captives

apply directly to the end customer (displayed by the red dots line in Figure 2). Importers and

manufactures can sell off their cars and funding directly to end customers, without the intervention of

a BOVAG enterprise.

The change in mind-set of end customers will lead to more demand for car related financial products

and full service products. But as already mentioned, most BOVAG enterprises are not in possession of

6 Again, figures are based on the VNA affiliated members only. They represent about 90% of the total lease

market. 7 This is stated in the Bovemij year report of 2012.

8 This is of course depending on the type of contract.

Page 13: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

5 Master Thesis Vincent Bakker 21-03-2014

sufficient capital to provide full service products and often do not have the capacity to manage such

products. Thereby, they are not able to come along with the changing market and they may lose a part

of the customer base or market share that shifts to a full service product. In order to prevent that, and

to ensure the continuity of BOVAG enterprises, it is important that they are able to offer full service

products.

The reasoning of BFM is that BOVAG car companies should have a lease department or leasing

company within their business. This enables them to offer full service products on their own. The task

of BFM is to be supportive in managing and funding financial car products of BOVAG enterprises, in

such a way that it enables them to offer (profitable) full service products and compete with the few

large companies.

With the acquisition of Care4Lease (C4L)9, the finance company has obtained key knowledge and

experience to facilitate universal and dealer companies in conducting a leasing company under its own

label. The complete administration and management of the BOVAG leasing company may be

organized and conducted by C4L. This enables the leasing department of car companies or leasing

companies to continue or start up their leasing activities, by outsourcing most if the administrative

activities. In addition to the outsourcing possibilities of administrative activities, the funding of lease

contracts is arranged by BFM. They provide the working capital that is needed to fund full service

products. This enables the finance company to provide financing and management to the BOVAG

leasing company. Figure 4 attempts to clarify the market position of the finance company (BFM and

C4L).

Figure 4: Roles of the Bovemij Financieringsmaatschappij (BFM), Care4Lease (C4L) and BOVAG enterprises in the

car sales market chain

9 Care4lease is a lease management and control company. They perform the complete control of leasing fleets of

universal or dealer leasing companies and mediate in the car financings and insurance components.

Confidential

Page 14: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

6 Master Thesis Vincent Bakker 21-03-2014

Outsourcing the management and financing of lease activities to C4L and BFM enables the leasing

department or company of BOVAG enterprises to offer (profitable) full service products and anticipate

on the changing mind-set of end customers. Hence, they expand their market with an additional

product that contributes to the continuity of the enterprises. They are able to serve customers interested

in full-service products, which otherwise would not be possible. So BFM provides support to BOVAG

enterprises to strengthen or regain their power and maintain their position in the car sales chain.

Moreover, favourable offered funding rates to BOVAG enterprises may lead to a slightly increased

margin.

BFM is funded with equity and debt provided by the group and a third party10

. However, the finance

company has not endless capital available to provide financings. The provided equity and debt is

limited to a height of €100 million. This capital capacity of €100 million is build-up of equity, internal

debt and external debt:

€15 million equity

€25 million internal debt

€60 million external debt

What actually happens, is that the problem of capital shortage of BOVAG enterprises moves towards

the finance company as the number of outstanding financings increases. As a result, working capital of

the finance company may dry up. This will possibly lead to capital shortage and could probably limit

the fast growing portfolio of car financing contracts of the finance company. Therefore, it is already of

importance to find a suitable funding solution in order to ensure the continuity of the finance

company.

One of the considerations for the capital shortage problem is the introduction of a securitization

funding strategy, by which the funding need of BOVAG members can be moved to the capital market.

Securitization of the asset portfolio of lease contracts of BFM has the potential to raise capital from

capital markets. Acting as a major joint player and centrally organizing the financing need of BOVAG

members, ensure a large financing demand based on a diversified customer base. In addition, BVG

enjoys the advantage of being a subsidiary of the BOVAG, giving them good insight in the operating

market and customers. The expectation is that securitization is a proper funding solution for the

finance company.

However, the introduction of securitization is not a guarantee for raising capital in a cost-effective

way. Securitization transactions are often very specific for different enterprises and asset types, which

makes it a complex technique to raise capital. It is more complicated than traditional financial products

like equity, bonds and loans. Moreover, the cost-effectiveness of a securitization is depending on

several risks and factors that influence the quality, costs and yield of a securitization transaction. For

new and (fast) growing enterprises it can be a big challenge to conduct a cost-effective securitization

program. The complexity of securitization makes it difficult to say in advance whether it is a cost-

effective way of raising capital.

1.2 Research objective & problem statement

In this research, we try to find out how securitization can be used and organized as a funding solution

for the finance company. This brings us to the following two research objectives:

10 The financial status of BFM is displayed in Appendix 3

Confidential

Page 15: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

7 Master Thesis Vincent Bakker 21-03-2014

The first objective is to investigate how the securitization of car financing contracts can be

organized as a suitable funding strategy in order to raise capital in a cost-effective way.

The second objective is to determine what adjustments need to be made to facilitate the

introduction of a securitization funding strategy.

We have defined the following sub goals to support the research objectives:

a) Understand the technique of securitization.

b) Understand how securitization can be applied to car financing assets.

c) Understand the influence of key rating drivers on the cost-effectiveness of a car financing

securitization program.

The following problem statement is used to accomplish both objectives: How can securitization of car

financing contracts be organized in order to raise capital in a cost-effective way and what

adjustments should be made to facilitate the introduction of a securitization funding strategy?

By answering the central research question it is possible to draw conclusions and recommendations in

which manner a securitization program can be realized as a cost-effective source of (external) funding.

The outcome of the study should result in an advice for the Bovemij Financieringsmaatschappij. This

advice should consist of the following deliverables:

In the first place, this study should provide clarity about the opportunities to perform a

feasible securitisation program in order to attract cost-effective capital. It should result in a

well-founded advice in which manner securitization can be structured in the most suitable

way for BFM.

In the second place, this study should deliver an advice what adjustments are necessary to

facilitate the introduction and quality of a securitization transaction.

1.2.1 Scope

This study will focus on the question how capital can be raised through securitization. The duration of

this thesis consist of a pre-research and 6 months of investigation and is delimited for time purposes in

order to provide a more detailed study on a specific subject.

Despite the fact that BFM supports BOVAG enterprises with their funding and management of car

financing products that enables them to offer full service products, there is a significant disadvantage

compared to the few large captives and leasing companies. This has to do with the purchase price of

the underlying car. BOVAG enterprises are unable to obtain (large) discounts on purchasing, because

of their relative low purchasing volume. Importers and manufacturers are willing to offer large

discounts on the purchase in case of a large volume orders. However, BOVAG enterprises have

neither the capital to buy large quantities nor the market to sell them. The major captives and leasing

companies do have the ability to buy large quantities. Moreover, they are often owned by

manufactures. This enables them to obtain high discounts (10%-25%) on volume purchasing. This

makes them more flexible and competitive with the determination of monthly payments to end

customers, by using significant lower selling prices and residual values in car financing contracts. It

may be difficult for BOVAG enterprises to compete with the few large companies (co-operation

between captives and importers & manufactures) in terms of prices.

The purchasing volume problem should not be underestimated, because of the impact on the monthly

payments. The rational customers will apply for the lowest price. The large discount on big volume

Confidential

Page 16: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

8 Master Thesis Vincent Bakker 21-03-2014

purchases of cars is an advantage for the major leasing companies. However, the procurement of the

cars is too complex and time consuming to be included in this study.

The possible internal overlap of provided products between the different business units could lead to

dissension between both units, which could have bad effects for the group. For example, BFD/BF uses

their partnerships with banks and captives to arrange beneficial insurances and financings for

(BOVAG) customers. However, the business unit BFM operates as a direct provider of financings. In

fact, BFM can be seen as a competitor of the partners of BFD/BF, which probably damage the

relationship of BFD/BF with banks and captives. There is a running discussion about the distribution

of different financial products among the business units, which is not extensively analysed within this

project. Nevertheless, the financial products offered by BFD/BF may be (partly) funded by BFM in

the future. We will take into account a possible expansion of the kind of car financings to be

securitized.

The research is not solely based on academic sources, but will also use information of a selection of

publications of rating agencies and opinions of experts in the field of securitization. In particular,

rating agencies play a key role in securitization.

1.3 Methodology & approach In order to obtain enough knowledge to formulate a substantiated answer to the central research

question, we have divided the central question into four research questions. In our opinion it should be

possible to answer the problem statement by solving the following research questions:

1. What is securitization?

Question 1 contributes to the objective of understanding the technique of securitization and the main

fundamentals of a securitization program (sub goal a). This question broadens our knowledge on

securitization funding solutions. We conduct a literature research11

in the fields of structured finance

and securitization to define the technique of securitization and determine how a securitization

transaction works. We examine and compare (pre and post crisis) papers of several authors on the

fundamentals of securitization, such as process, transaction participants and motivation. The following

sub questions will support us to formulate an answer to research question 1:

a) What are the fundamentals of securitization?

b) How does securitization work?

c) What are the motivations behind securitization?

2. What are the potential car financing assets to be securitized and what are the characteristics

of these assets?

Question 2 is used to understand how securitization can be applied to the potential asset portfolio (sub

goal b).We determine the type of assets of the finance company that are eligible for securitization

purposes. We do that by analysing documents & data related to the current portfolio and conducting

interviews with employees about the business processes. Moreover, we try to clarify the expected

development of the portfolio. For the determination of the strategy, it is important to know what the

11 The master thesis syllabus (2012) (University of Twente, Industrial Engineering and Management) is used as a

guideline for the literature research.

Confidential

Page 17: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

9 Master Thesis Vincent Bakker 21-03-2014

expected growth and expansion will be in the future. The following sub questions will support us to

formulate an answer to research question 2:

a) What different kind of financial products are offered by BFM/C4L?

b) How are the contracts structured?

c) How will the portfolio develop?

d) What are the requirements for car financing asset securitization?

3. Which ABS structure is most suitable to BFM for the organization of the securitization of the

asset portfolio of the finance company?

Question 3 is used to understand how securitization can be applied to the potential asset portfolio (sub

goal b). First, we examine different kinds of securitization structures discussed in the literature. In

particular, the work of Sabarwal, (2006); and Tavakoli (2008) discuss a number of structures that have

the potential to be suitable for the car financing asset portfolio of the finance company. Moreover, we

try to determine the main differences between these potential structures. Within the literature, we

could not find an assessment model to evaluate different structures. Only a couple of criteria are

mentioned by some authors. Therefore, we try to develop an assessment model in order to determine

which structure is the most suitable to BFM. The assessment is based on a number of criteria derived

from the work of Fabozzi & Choudhry (2004); Fitch (2001); Sabarwal (2006); and Tavakoli (2008).

The following sub questions will support us to formulate an answer to research question 3:

a) What are the common structures of (true sale) ABS?

b) What are the differences between these structures?

c) How to assess which of the structures best suits to BFM?

4. What are the key rating drivers that influence the cost-effectiveness of the car financing

securitization program and how do you control them?

Question 4 is used to understand the influence of key rating drivers on the cost-effectiveness of a

securitization program (sub goal c). We identify and quantify the key rating drivers that influence the

cost-effectiveness of a securitization program and clarify the important role of rating agencies in

securitization programs. Rating agencies have a key role in determining the credit rating and thus have

a large impact on the pricing and cost-effectiveness of the securitization. We investigate the

approaches and requirements of S&P, Fitch and Moody‟s to determine the decisive risks and factors

that determine the credit rating, pricing & cost-effectiveness. Additional literature research enables us

to quantify these risks. We try to create a framework of the key rating drivers, to get control of the

influencing factors and indicators on the cost-effectiveness of the securitization program. Therewith, a

clear overview of the most important organizational aspects of securitization can be established for the

case of BFM. The following questions will support us to formulate an answer to research question 4:

a) What are the requirements for an efficient securitization?

b) What are the key rating drivers (according to rating agencies) involved in a car related

securitization?

c) How to quantify and control the key rating drivers?

1.4 Report structure This report comprises six chapters. In chapter one, we have started with a description of the subject of

this master thesis. We have explained the background of the research topic, which is particularly

Page 18: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

10 Master Thesis Vincent Bakker 21-03-2014

important to understand the relevance of this study. Furthermore, we have defined the goal, problem

statement and methodology of the study.

In the second chapter, we will define the technique of securitization and explain how securitization

works. We will regularly refer to the case of BFM. This chapter enables us to answer the first research

question and may already introduce some of the topics treated by other research question.

In the third chapter, we will determine what type of assets or receivables of the finance company are

eligible for securitization purposes. We will discuss the several contract types and their structures.

Moreover, we focus on the expected growth and expansion of the asset portfolio of the finance

company. This enables us to answer research question two.

In the fourth chapter, we will discuss the securitization structures that have the potential to be suitable

for the car financing asset portfolio. We explain them one by one and determine the main differences

between the structures. Based on a number of criteria, we are able to determine the extent to which the

structures best fit to the motivation and needs of the finance company. This chapter enables us to

answer research question three.

In the fifth chapter, we create a framework of key rating drivers and rating drivers in order to get

control of the influencing factors and indicators on the cost-effectiveness of the securitization

transaction. We identify and quantify the key rating drivers that influence the cost-effectiveness of a

securitization program. It focuses on the main risks identified by the rating agencies. This provides

insight into key organization aspects of securitization for the case of BFM and enables us to answer

research question four.

In the final chapter, we try to give a substantiated answer to the central research question. This chapter

contains the conclusions and recommendations of the research. We describe the necessary changes

that will facilitate the introduction of a securitization funding strategy. We summarize our research

findings and reflect to the strong and weak points of our findings, methodology and approach in a

discussion.

Page 19: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

11 Master Thesis Vincent Bakker 21-03-2014

Chapter 2: Securitization The objective of this chapter is to gain knowledge on the topic of securitization for BFM, by defining

and understanding the technique of securitization and its fundamentals. This chapter serves as a

general introduction to the topic of securitization, in order to broaden the knowledge of BFM. In the

remaining chapters, we will frequently refer to specific sections and terms in this chapter.

Securitization is a structured finance technique that has the potential to raise cost-effective capital

from capital markets by selling securities that are backed by assets. Several types of asset portfolios

can be securitized in different ways, depending on the properties of the assets and the wishes of the

originator (executor of the securitization). The technique is introduced in the 1970s on the U.S.

mortgage market, where a mixture of mortgages was pooled and converted into tradable securities

with mortgages as collateral. Later on, securitization was used to securitize non-mortgage assets, like

car loans, student loans, credit cards receivables and equipment leases (Carey & Stulz, 2007). The first

securitization transaction in the Netherlands was in 1996 (DNB, 2005).

Fabozzi & Choudhry (2004); and Vink & Thibault (2009) report that the securitization market is

divided into three main categories: Asset-Backed Securities (ABS), Mortgage-Backed Securities

(MBS) and Collateralized Debt Obligations (CDO). ABS are backed by a securitized pool of

consumer or commercial related assets of a certain type. Examples of assets in ABS are consumer

loans, car loans, car leases and credit cards receivables (Vink & Thibault, 2009). MBS are securities

which are exclusively backed by credit or loans from mortgages (Martínez-Solano, Yagüe-Guirao, &

López-Martínez, 2009). This main type of securitization is often divided into Commercial Mortgage

Backed Securities (CMBS) and Residential Mortgages Backed Securities (RMBS). CMBS are

securitizations of commercial real estate mortgages. RMBS are securitization of residential mortgages.

A CDO is a less standardised form of securitization. CDOs are backed by a portfolio of assets that

may exist of a portfolio of ABS, bonds, business loans, securitized receivables, and tranches of other

CDOs or similar financial assets (Tavakoli, 2008).

In this research we are focussed on ABS transaction, because the car financing related assets (car loans

and leases) of BFM fall within this category. However, ABS can be subdivided into several variants

with specific characteristics. The choice of an ABS structure is depending on the asset type and need

& motivation of BFM to use it a securitization funding strategy. In Chapter 4, we discuss various ABS

structures that are suitable for the asset portfolio and incentives of BFM.

Within this chapter we try to define the word securitization and answer research question (1): What is

securitization? We start with a comparison of several (pre and post crisis) literature studies and books

to define the technique of securitization. Then, we explain why companies use securitization and why

it is interesting for investors to invest in ABS. In addition, we will highlight the negative side of

securitization, which was brought to light during the emergence of the crisis. Thereafter, we define

how a conventional securitization process works and what participants are involved in the process.

Next, we describe the main fundamentals of securitization. We determine the role of what is called a

special purpose vehicle (SPV), credit enhancement and credit ratings. During this chapter, we try to

link the theoretical concepts to the context of this research.

2.1 Definition of securitization Despite the fact that many authors in various studies and books have paid attention to the concept of

securitization, there is no general accepted definition of securitization. Nevertheless, some of them

have attempted to define securitization. Mansini & Sparanza (2002) have defined securitization as:

Page 20: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

12 Master Thesis Vincent Bakker 21-03-2014

“A financial operation which allows financial institutions to transform unmarketable financial

assets, such as mortgage assets, or lease contracts, into marketable securities.”

This definition emphasizes on the important property of securitization of transforming unmarketable

assets into marketable securities. In other words, illiquid assets are converted into liquid assets.

Fabozzi, Davis, & Choudhry (2006) confirmed that the conversion of not readily marketable assets

into tradable securities belongs in the definition of securitization. In addition, they say that

securitization can be applied to financial institutions, such as banks, insurance & finance companies

and nonfinancial corporations. However, the definition above is in our opinion insufficient in the asset

qualifications and the way of transformation. Jobst (2006) added some more details to the definition of

securitization:

“Securitization converts regular and classifiable cash flows from a diversified portfolio of

illiquid present or future receivables of varying maturity and quality into negotiable capital

market paper issued by either the originator of the securitised assets/receivables or a non-

recourse, single-asset finance company (“special-purpose vehicle” (SPV))."

This definition is more detailed in defining what actually is converted. It creates a distinction between

different types of assets that may or may not qualify for securitization. Assets should meet the

requirement of generating a regular and classifiable cash flow.

While the definition of Jobst (2006) is very clear formulated, it is not entirely perfect. A property of

the securitization process that is missing in the definition above is that the repayment of the issued

securities is not depending on the financial capacity of the originator, but solely based on the cash flow

generated by the assets (PWC, 2006; Vink, 2009; and Vink & Thibeault, 2009). Based on definitions

and characteristics in the literature (Fabozzi, Davis, & Choudhry, 2006; Jobst, 2005; Mansini &

Sparanza, 2002; Vink, 2009; and Vink & Thibeault, 2009), securitization is clearly defined for the

remainder of this report as:

A structured finance technique in which a collection of unmarketable, regular and

predictable cash flow generating assets that may vary in maturity and quality, are converted

into marketable securities. These securities are issued by a legal entity (SPV) and sold to

(institutional) investors, who are repaid with interest and principal payments generated by

the asset portfolio.

2.2 Motivation for securitization

Securitization can offer several benefits to the originator or executor and investors of the

securitization. Prior to the process of securitization, there should be a reason for starting a

securitization. The main motivations for securitizing a pool of assets are summarized in this section.

We have separated the motivations from originator and investor perspectives.

2.2.1 General motivation of originators

According to Fabozzi & Kothari (2007); Jobst (2005); and Litwin & Levy (2000) the frequently

mentioned key motivations for the originator of securitization of assets are mentioned below (several

terms are explained further in this section):

Raising capital by an alternative source of funding. Under circumstances it could be

possible that the originator is unable to acquire funding through other funding alternatives, due

to financial stress or other reasons. Securitization could be a potential outcome to attract

investors and raise capital, because of the independent structure of the securitization process.

Originators can raise capital from capital markets as alternative (cheaper) source of funding.

Page 21: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

13 Master Thesis Vincent Bakker 21-03-2014

The potential for reducing funding costs. The funding costs are depending on the assigned

credit rating of the securitization transaction that is achieved by a credit rating agency.

Securitization enables the originator to sell off their assets to a legal entity (Special Purpose

Vehicle). The property of the entity is that it is independent of the originating company, which

isolates the asset pool from potential bankruptcy risks of the originator. This enables them to

achieve a higher credit rating on the „isolated‟ asset portfolio than the originating company

could achieve on its “whole” business, which results in lower funding interest rates for the

specific asset pool because of the higher credit rating.

Achieving off balance sheet funding. Many institutions use the technique of securitization

for relief of regulatory capital. Securitization enables them to remove assets from their balance

sheet and fund them off balance (on the balance of the special purpose vehicle). It enhances

key financial ratios, like return on equity, due to the reduction of the amount of on-balance

leverage. Especially banks use the technique of securitization to increase funding possibilities.

However, full capital relief is (most of the time) not achieved, because of the requirements of

credit enhancement and retained interest. Furthermore, analysts do not only focus on balance

leverage, but also investigate the off balance positions.

Risk transfer: Managing corporate risk. By using the technique of securitization it is

possible to sell assets to an intermediate entity or special purpose vehicle. This ensures that the

originating company is no longer exposed to the total credit risk and interest rate risk of the

pooled assets. Investors of the securities issued by the SPV bear the risk of the asset portfolio.

2.2.2 Motivation of BFM

The most important reason to consider a securitization transaction for BFM is to raise capital. As

explained in Section 1.1, further growth of the asset portfolio can lead to capital shortage if liquidity

dries up. Equity and debt are limited to a certain level. The securitization of its assets will result in

new capital or liquidity in order to continue its business. The second most important reason for BFM is

to manage corporate risk to transmit and reduce the exposure to certain risks. The reduction in funding

costs is less important, but it is desirable that the funding costs will be a cost-effective source of

funding. It is not relevant for BFM whether the funding is achieved off -or on balance. However, as

the business continues to grow and thus may affect the balance sheet, it is quite possible that the

motivations for using a securitization funding strategy may change.

2.2.3 General motivation of investors

For investors, securitization is an investment tool that (has the potential to) provide fixed interest

income (BIS, 2011; and Feng & Long, 2010). The main reasons for investors to invest in ABS are

summarized as follows:

Tailor-made risk/reward levels. Investing in an asset-backed security gives investors the

opportunity to assess the level of risk against the potential reward. They can determine the

size and risk level of their investment, due to various tranches that differ in size, risk and

return profile (explained in more detail in Section 2.6.1).

The potential for diversifying investment sources. It enables investors to diversify their

risk exposure. It enables them to invest in a pool of assets from the originating company

instead of investing in the company itself.

Access to investment sectors which are otherwise not possible for them to invest in.

Securitization allows investors to invest in assets pools which are normally not available to

them.

Confidential

Page 22: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

14 Master Thesis Vincent Bakker 21-03-2014

Clarity about risk profile through credit rating. The securitization structure is extensively

analysed by rating agency. They analyse the whole structure of securitization from collateral

to the origination company. Consequently, the investor can rely on the credit rating from an

agency as a fundament for his investment.

2.2.4 Drawbacks

Despite all outlined benefits, securitization transactions do not guarantee positive outcomes. The

transaction could be a rather complex funding structure. Securitization has been designated as one of

the causes of the credit crisis in 2007. One of the reasons is that the expected losses have been

calculated inaccurately by rating agencies. Insufficient control & understandability of the quality of

the underlying assets and the absence of data on the performance of the underlying asset portfolios

have resulted in incorrect credit ratings (Vink, 2009). The ratings were based on complex models, in

which the parameters were highly sensitive to small changes. Wrong estimation techniques and

assumptions had a major impact on performance of a securitization transaction and were misleading

with respect to the impact of realized defaults (Segoviano, Jones, Lindner, & Blankenheim, 2013).

Besides that, securitization was often used as an “originate-and-distribute” business model. The

originator was more focused on originating assets and selling them into a securitization transaction.

They did not bear the credit risk of borrower defaults, but often did have the control of the

securitization transaction. Their focus on originating more assets for securitization purposes has led to

deterioration in credit quality of the underlying assets (Malamud, Rui, & Whinston, 2012). Moreover,

the credit crisis has revealed several other shortcomings of securitization (see also Caprio, Demigrüc-

Kunt, & Kane, 2008; and Segoviano, Jones, Lindner, & Blankenheim, 2013). Therefore, it is important

to weigh the advantages against the complexity of conducting a securitization.

2.3 Process of securitization In practice, securitization transactions are structured according to the needs and purposes of the

originator. The originator is the executor or party with securitization needs. The main motivation to

introduce a securitization funding strategy for BFM is to raise capital. This can be achieved by a true

sale ABS transaction. A true sale is a sale transaction in which the originator is remoted from the asset

portfolio in terms of economic and legal base (Sullivan, 1998). The literature is very consistent in how

a typical true sale ABS is structured. The structure described here serves as the foundation for

structures of true sale securitizations and provides insight into the mechanism of securitization. Based

on the studies from Carey & Stulz (2007); Fabozzi & Choudhry (2004); Fabozzi & Kothari (2007);

Feng & Long (2010); Jobst (2005); Klee & Butler (2002); and Vink (2009), the process of a typical

true sale securitization should involve the following steps:

Step 1: In the first step, the originator (BFM) identifies a collection of unmarketable, regular and

predictable cash flow generating assets that qualify for securitization purposes and pool them

together into a portfolio, the “portfolio of assets”.

Step 2: In the second step, the originator sells the portfolio of assets as a true sale to the issuer of the

securitization, which is called a Special Purpose Vehicle (SPV) or trust which is exclusively

set up for securitization purposes by the originator. The true sale of the originator‟s asset

portfolio will have an effect on the balance of the originating enterprise and the SPV. This

ensures that the assets are isolated from the firms‟ balance. It is thereby possible to determine

a credit rating that is solely based on the isolated portfolio. Section 2.4 covers the legal

structure of an SPV in more detail. The proceeds from the true sale will increase the capital of

the originator.

Page 23: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

15 Master Thesis Vincent Bakker 21-03-2014

Step 3: In the third step, the SPV converts the asset portfolio into a set of securities in order to finance

the true sale as cheap as possible. The securities can be divided into tranches with different

risk and yield profiles. This ensures that different credit ratings can be assigned to different

parts of the portfolio based on the risk and yield profiles. The allocation among different

tranches is called subordination. Subordination divides the securities into different tranches,

with specific risk profiles from very low risky investment (senior notes) to medium risky

investments (mezzanine notes) and high risky investments (junior/ equity notes). It can

increase the credit worthiness of upper tranches. This is explained in more detail in Section

2.6.

Step 4: In the fourth step, the quality of the portfolio of assets is examined by one or more rating

agencies to achieve a credit rating for the different tranches, which improves the marketability

of the securities. The effect of a default in the portfolio can be negligible through

diversification in the portfolio. On top of that, the portfolio is isolated from the originators

balance and bankruptcy risk of the originator. Therefore, a large part of the securities can be

rated with the highest credit rating. Higher credit ratings have the possibility to provide

cheaper the funding. In most cases, it is for investors impossible or too time-consuming to

analyse and evaluate the underlying assets portfolio. A credit rating facilitates the

consideration to invest in the portfolio. Later on, we will discuss the role of the rating agency

and their credit rating.

Step 5: In the fifth step, the securities (issued by the SPV) are sold to (institutional) investors. Due to

clear risk profiles and credit ratings, it is possible for investors to invest in securities with an

appropriate risk and yield profile. The proceeds from the sale of notes, received from

investors, are transferred through the SPV and used to pay for the true sale transaction with the

originator. The issuer uses the proceeds to purchase the portfolio of assets from the originator.

Investors will receive interest and principal payments depending on the performance of the

securitized asset portfolio.

Step 6: In the sixth step, the securitization process will be serviced and controlled. Normally, the

originator of the securitization is also the servicer of the asset portfolio and controls the

transfer of cash flows, but it can also be serviced and controlled by third parties.

In spite of the fact that the steps are numbered in the most logical order, there is no mandatory order of

steps. In addition, the number of steps and extent of each step can differ from another. The true sale

securitization process is summarized in Figure 5. The described steps of the securitization process

should not strictly be followed in this order. In fact, several steps can and will be undertaken

simultaneously.

Page 24: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

16 Master Thesis Vincent Bakker 21-03-2014

Figure 5: structure, flows and roles of a typical true sale securitization process.

The securitization transaction involves a number of roles performed by various transaction

participants. A number of these roles have already been mentioned above and in Figure 5. The precise

number of roles is depending on the deal-specific securitization structure. Based on BIS (2009); CEBS

(2010); PWC (2006); and Telpner (2003), we have summarized a list of roles involved in a typical

securitization process in Table 2. However, depending on the deal-specific securitization structure, it

may occur that there are additional roles and transaction participants involved.

Role in the securitization process

Description of the role

Originator The role of the originators is to create the assets to be securitized or

owner of already created assets to be securitized. It is the party with the

incentive to perform a securitization transaction. They sell the assets to

the securitization entity (SPV). Originators are sometimes also

mentioned as the seller or executor of the securitization process.

Sponsor The sponsor is a credit institution other than the originator that

establishes and manages a securitization scheme or asset-backed

commercial paper programme on behalf of third parties. This is

sometime also called the program manager or program administrator

Obligor The obligor is a party or end user of the underlying assets, which are

ultimately responsible for the payment stream. They are responsible for

the cash flow stream and performance of the portfolio.

Issuer The role of the issuer is buying and holding the asset portfolio from the

originator and issuing securities. The issuer is in most cases structured as

an SPV. This entity enables the isolation of the asset portfolio from the

originator. Because the issuer has a pivotal role in the securitization

Page 25: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

17 Master Thesis Vincent Bakker 21-03-2014

structure, it is discussed in more detail in Section 2.4.

(Institutional) Investor

The role of the investor is to buy the securities and bear the risks of the

portfolio losses. Part of the securities can be taken back by the originator

and is called retained interest in the securitization.

Rating agency An independent third party will evaluate the securitization structure,

quality and rating agencies assign credit ratings to the securities. This

enables investors to invest in a suitable risk profile, without a thorough

analysis of the asset portfolio.

Servicer The role of the servicer is to control and manage the asset pool and day-

to-day operations, collecting the principal and interest payments from

obligors. In most cases, the originator acts as the servicer of the

securitization. The servicer is sometimes mentioned as the administrator

of the SPV.

Credit enhancement (CE) provider

The role of a credit enhancement provider is to provide guarantees and

improvements for the credit risk in the portfolio. It can be used to cover

losses in the asset portfolio to repay interest payments and principal to

note holders.

Liquidity provider The liquidity provider supports in mismatches between collected cash

flows from the asset portfolio and the distributed cash flow under the

structured securities. Moreover, a liquidity provider is used in asset-

backed commercial paper structures to support asset liability mismatch

of medium to long term assets and short term commercial paper (this is

explained in more detail in Section 4.3).

Underwriter An investment bank or third party involved in structuring, underwriting

and marketing of the securities that is responsible for attracting potential

investors and the sale of securities.

Trustee Third party that oversees the proper functioning of the SPV. This is often

an unaffiliated party that is the owner of the SPV.

Paying agent A bank that arranges the settlement of payments on securities to

investors and provides cash and banking administration services for the

issuer.

Legal, tax and accounting advisers

Parties that provide assistance in legal, tax and accounting structures

through the process of securitization from third parties

Swap counterparty The swap counterparty is a third party which is involved in the swap

transaction. Their role is to hedge the issuer against interest rate risk. An

interest rate swap is used to cover interest losses, that arise when floating

(fixed) rates are received and fixed (floating) rates are distributed to

investors. Table 2: Roles in a securitization process.

The roles are performed by transaction participants who are chosen by the originator or sponsor of the

of the securitization transaction. Some roles may be carried out by one and the same transaction

participant. For example, the BFM will be the originator of the securitization, but may also be the

servicer of the asset portfolio hold by the SPV, the CE provider, the liquidity provider, the investor,

and the swap counterparty. The sponsor may also be liquidity provider, underwriter, paying agent,

servicer and swap counterparty. Moreover, it is also possible that multiple parties have the same role

in the securitization process.

2.3.1 Balance sheet consequences

The following example explains the working and balance sheet effects of a (true sale) securitization.

The example is based on the work of Gangwani (1998); and Kane (1997). A fictive finance company

ABC invests parts of its money in car leases with equity and unsecured debt (see Figure 6). We

Page 26: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

18 Master Thesis Vincent Bakker 21-03-2014

assume that the company has invested €1000 in lease contracts and no cash is available (liquid assets).

Their liabilities consist of €200 equity and €800 debt. The current debt capital capacity is €800. Their

liquid assets are dried up, meaning that there is a need for new cash in order to continue their funding

businesses.

Figure 6: Initial balance sheet of ABC (example)

There are multiple ways to increase capital for the company in order to continue their funding

businesses. Normally, debt is cheaper than equity and it is therefore logical to look at the possibilities

of increasing debt first. One of the easiest ways to raise debt capital is through an unsecured bank loan.

A bank is able to offer an unsecured loan to ABC, with a rate based on the financial status (credit

rating of the company) and performance of its business. However, this may be an expensive form of

borrowing money and is often limited to certain leverage ratios. Moreover, the interest rate asked by

the bank or funder will increase, because the higher leverage ratio. An alternative way of funding is to

use the current assets as collateral. In that case, a selected part of the assets can be pledged against the

loan and is called secured debt (not a true sale, assets stay on-balance). This enables ABC to get a

slightly better interest rate on its debts than in the case with unsecured debt. The balance sheet effects

of secured debt are shown in Figure 7.

Figure 7: Balance sheet effects of entering a secured loan transaction (example).

Besides the increase in liquid assets of €500 cash, there is also an increase in debt, where a secured

loan of €500 is added to the company. Debt-equity ratio will increase from 4.0(=800/200) to

7.5(=1500/200). The increased leverage will lead to a higher interest rate asked by the bank or funder.

A next, and potentially better alternative, could be introducing a securitization program. In the

securitization transaction the lease assets will be funded off balance. The bundle of illiquid assets

(€500 of lease contracts), identified as described in step 1 of the securitization process, is sold to an

SPV and converted to securities. The proceeds from the sale of the assets are transferred to ABC (+

€500 liquid assets). The SPV serves as a pass-through and is the buyer and owner of the bundle of

illiquid assets, financed by the issued securities. The balance sheet effect of the securitization

transaction is illustrated in Figure 8. This enables ABC to fund a part of its assets off balance in the

SPV.

Initial situation

Assets Liabilities

Liquid assets -€ Equity 200€

Lease contracts 1.000€ Debt 800€

1.000€ 1.000€

Initial situation Situation with secured debt

Assets Liabilities Assets Liabilities

Liquid assets -€ Equity 200€ Liquid assets 500€ Equity 200€

Lease contracts 1.000€ Debt 800€ lease contracts 1.000€ Unsecured debt 800€

Secured debt 500€

1.000€ 1.000€ 1.500€ 1.500€

Page 27: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

19 Master Thesis Vincent Bakker 21-03-2014

Figure 8: Balance sheet effects of introducing a securitization transaction for ABC (example).

If we compare the securitization solution with the secured debt solution, we see that securitization

provides new capital without changing the total balance sheet value. Thence, the debt –equity ratio of

ABC will not change (800/200=4). Moreover, a large part of the current debt capital position can be

redeemed, which will decrease the total balance sheet value and debt-equity ratio of ABC.

Additionally, securitization has the potential to obtain lower interest expenses, because the interest rate

is based on the isolated asset portfolio. This results in more costs savings on interest charges.

However, securitization involves certain costs that have to be offset by the lower interest rate. That

means that securitization must contain a certain volume in order to realize a cheaper way of raising

capital compared to secured debt.

It may be that it is not the incentive to perform a securitization with the objective of raising capital, but

reducing credit risks of a specific portfolio of (financial) assets. In that case, it is also possible to

conduct a synthetic securitization transaction instead of a true sale transaction. This type of

securitization differs from a true sale transaction in terms of transferring the ownership of the assets. A

synthetic structure is focussed on transferring the credit risk, instead of selling the assets itself

(Fabozzi & Choudhry, 2004). This is done through entering into a credit default swap (CDS) with an

SPV. In case of a default in the asset portfolio, the SPV will guarantee the losses experienced by

originator. The portfolio of assets is not sold, and thus not raises capital for the originator. So,

synthetic structures can be used for the reduction of credit risk exposures. However, this structure does

not fit the main motivation of BFM to obtain additional capital. We refer to Appendix 4 for a more

detailed explanation about the synthetic structure.

2.4 Special purpose vehicle (SPV) A usual step in the process of securitization is the creation of a legal entity or a trust, often called a

special purpose vehicle (SPV). Sometimes it is referred as a special purpose entity (SPE), special

purpose trust (SPT) or special purpose company (SPC). For the remainder of this thesis we will

classify it as an SPV. An SPV serves as a pass-through vehicle between originator and investors for

the transformation of illiquid assets into liquid securities and must protect investors in case of

bankruptcy events of the asset originator (Klee & Butler, 2002). Gorton & Souleles (2007, p. 555)

defined an SPV as: “a legal entity created by a firm (known as the sponsor or originator) by

transferring assets or receivables to the SPV, to carry out some specific purpose or circumscribed

activity, or a series of such transactions”. Others, such as BIS (2009); and Vink & Thibeault (2010),

have defined it in the same manner without too many varying views as an entity with some specific

purposes that is (usually) created by a financial institution to purchase and facilitate the sale of assets.

Initial situation Situation with securitization

Assets Liabilities Assets Liabilities

Liquid assets -€ Equity 200€ Liquid assets 500€ Equity 200€

Lease contracts 1.000€ Debt 800€ Lease contracts 500€ Debt 800€

1.000€ 1.000€ 1.000€ 1.000€

SPV's balance

Assets Liabilities

Bundel of 500€ Senior securities 400€

lease contracts Mezzanine securities 50€

Equity securities 50€

500€ 500€

Page 28: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

20 Master Thesis Vincent Bakker 21-03-2014

An SPV may take the legal form of a limited liability company (besloten vennootschap met beperkte

aansprakelijkheid), a trust (stichting), or a corporation (Gorton & Souleles, 2003; Johnson & MacIvor,

2012; and Klee & Butler, 2002). The choice of the legal form is depending on tax and accounting

issues. In most Dutch securitizations, the SPV takes the legal form of a trust or limited liability

company. The SPV may be a subsidiary of the originator or sponsor, or an orphan company12

, but may

not be consolidated with the originator/sponsor for tax, accounting and legal purposes. SPV‟s are

usually tax neutral structured, which means that profits of SPV‟s are not taxed (Gourton & Souleles,

2003). However, when tax neutrality SPV is not achieved, it will lead to double taxation for the

originator of the SPV and most likely will make the securitization transaction unprofitable.

The SPV should be designed bankruptcy remote from the originator of the assets and any other

creditor (Klee, & Butler, 2002). The bankruptcy remote feature is used to separate the SPV entity from

the originating or sponsoring company in case they enter into a bankruptcy procedure (Tavakoli,

2008). This ensures that creditors can have no possible claim against the SPV or its assets, in case of

bankruptcy of the originating company, due to the isolation of the asset portfolio from the originators

balance sheet. This can be achieved by a true sale of the asset portfolio, in which the SPV becomes the

legal owner of the assets. Due to the fact that the pool of assets is separated from the bankruptcy risk

of the originator, it has the potential to ensure much lower funding costs (Fabozzi & Kothari, 2007;

and Vink, 2009). The isolation of the assets enables the originator to increase the creditworthiness of

the asset portfolio. Bankruptcy remote also means that the SPV itself can never become bankruptcy

(Gorton & Souleles, 2003). To achieve that, the SPV structure is limited to several restrictions.

Other purposes of an SPV are holding the specified pool of assets and issuing securities against these

assets, which can be divided into different risk tranches (Fabozzi & Choudhry, 2004). SPVs are

(normally) managed by the servicer. The operational and business decisions of the SPV are made by

the originator and servicer. Moreover, they have no physical location nor independent management or

employees.

2.5 Credit rating As already mentioned, rating agencies play a key role in the process of securitization. A credit rating is

an assessment of the creditworthiness of an entity, debt instrument or other financial instrument to be

financed in a normal way (Haan & Amtenbrink, 2011). One of the main reasons for the existence of

credit ratings is enhancing the asymmetric information between sellers and buyers of debt instruments

(DeMarzo, 2005). Asymmetric information between sellers and buyers is a problem in the sense that

buyers face a lack of information and are not able to adequately assess the credit risk of certain debt

instruments or companies. This ensures that no proper prices can be established between buyers and

sellers. It is the job of rating agencies to bridge this gap and provide reliable standardized information

to the market in the form of a credit rating. Credit ratings are marked as standardized information and

are not characterized by geographic factors nor the type of instruments rated, allowing investors to

compare different types of investments based on credit ratings (Groeneveld, 2008). It is possible to sell

securities against better (interest) prices by obtaining a rating for securities, because that makes them

more marketable and comparable to other investments.

According to DNB, there are around 150 credit rating agencies, but 95% of the market share is

represented by three major rating agencies: Fitch Ratings (Fitch), Moody‟s Investors Service

12 An orphan company‟s shares are held by a trustee and is not beneficially owned by someone on a non-

charitable bases (source: Investopedia)

Page 29: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

21 Master Thesis Vincent Bakker 21-03-2014

(Moody‟s) and Standard & Poor‟s (S&P) (Haan & Amtenbrink, 2011). They use different scales of

letters to determine the creditworthiness of debt instruments or companies. Roughly, a distinction is

made between high grade and low grade investments. The highest rating is indicated by AAA (S&P,

Fitch) or Aaa (Moody‟s). The lowest grade is indicated by D (Moody‟s, S&P) or DDD (Fitch). In spite

of the fact that the agencies use different scales, they are comparable. Appendix 5 contains a

comparative table of all investment grades of the three major rating agencies.

The three common rating agencies Fitch, Moody‟s and S&P have their own approaches for the

analysis of car lease ABS (see Fitch, 2011; Moody‟s, 2011a; and S&P, 2011). They use various

assessment approaches for different types of assets, because each type of assets has its own

characteristics and risks that affect the creditworthiness of the securitization transaction. A credit

rating in a securitization is primary based on credit risk. Credit risk is the risk that the obligor will

default on its obligation to make periodically payments under an agreed contract, resulting in a loss

(Doff, 2005; and S&P, 2011). The final determination of credit risk and related credit ratings is done

by rating agencies.

Rating agencies quantify the exposure to credit risk in a car lease securitization by an estimation of the

default and loss distributions. The models used by rating agencies are quantitative tools to determine

the portfolio default and loss distribution (Fitch, 2006; and Groenveld, 2008). Despite the different

approaches between agencies, they use their own Monte Carlo simulation models in order to

determine a credit rating (Groenveld, 2008). They run their analysis on a wide pool of portfolio data

which is an important input requirement to achieve a proper credit rating. A key input to predict the

future pool performance is based on historical performance data. Rating agents try to estimate a full

probability distribution of the expected credit loss of the pool and its variance, based on the estimates

of the expected credit loss and its variance (Fitch, 2011; and Moody‟s, 2011a). It is important for

originators to properly maintain all relevant data. In the remaining chapters, we try to determine the

relevant data for the case of BFM. The key rating drivers for car financing securitizations are

identified in Chapter 5.

2.6 Credit enhancement In order to obtain greater certainty in the securitization transaction, it is possible to enhance the quality

and performance of the securitization process. Credit enhancement (kredietondersteuning) is a method

to achieve greater certainty and thus improve credit ratings from rating agencies by using features to

mitigate several risks in the pool of assets. It is needed to protect investors against certain level of

losses due to poor performance of the collateral (Gupta et al, 2007). Credit enhancement can be

divided into internal and external credit enhancement. Internal credit enhancement is a form of

enhancement in which the credit protection is obtained from collective generating cash flows (Gupta et

al, 2007). Externally generated credit enhancement involves a third party which provides a form of

guarantee in case of bad performance of the collateral against a certain fee (Gupta et al, 2007).

Credit enhancement can be used to improve the credit rating and lower interest rates on securities.

However, any shape and extent of credit enhancement provides a certain cost. It is important to make

an assessment on the benefits and costs of credit enhancement in order to achieve a high as possible

credit rating against covered expenses in the securitization process (Fabozzi, Davis, & Choudhry,

2006). The alignment of the level of credit enhancement is generally done in consultation with the

credit rating agency in order to obtain a preferable credit rating.

Below we describe the different internal and external forms of credit enhancement. The common types

of internally generated credit enhancement are excess spread, subordination, reserve accounts and

Page 30: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

22 Master Thesis Vincent Bakker 21-03-2014

overcollateralization. The common external types explained in this section are monoline insurance and

letter of credits. Depending on the asset portfolio characteristics and securitization purposes, one or

more of the following described credit enhancement methods can be used to improve credit ratings.

However, specific securitization structures or characteristics can provide additional credit

enhancement options or risk mitigations in order to improve the quality of the securitization.

2.6.1 Subordination

One of the regular methods to credit enhance the securitization process is subordination. As described

in Section 2.3, the issued securities are often divided into different tranches which have their own risk

and yield profile. Subordination is the process of dividing the total amount of assets into sub tranches.

The structure of the subordination is crucial for the determination of the credit ratings of different

tranches. Usually, there are a couple of tranches within a securitization structure, which are ranked

from low to high risk level. A securitization can consist of many different subordination structures.

Like others (Fabozzi, Davis, & Choudhry, 2006; and Vink, 2009), we assume that the conventional

securitization structure is composed of three tranches: senior tranche, mezzanine tranche and equity

tranche. In practice, higher or lower number of tranches can be used in order to obtain the desired risk

profiles and credit ratings. Figure 9 displays how an asset pool is subordinated into three tranches.

Figure 9: Asset pool subordination structure

Every tranche has its own repayment prioritisation and volume. Depending on these variables, it is

possible to determine a specific risk and yield profile of a particular tranche. In most cases of

securitization, there is a prioritisation of repayment to investors, which is often referred to as the cash

flow waterfall (Fabozzi & Choudhry, 2006). The highest ranked tranche (the senior tranche) is fully

reimbursed before other tranches receive anything. Then, the second highest ranked tranche

(mezzanine tranche) is fully reimbursed before other tranches receive anything, and so on. This means

that the equity tranche is the most risky tranche, since the first losses are absorbed by this tranche.

Besides the prioritisation of repayments, volume is the other variable that determines the risk and yield

profile of different tranches. Tranches can differ in volume or percentage of the total asset amount. In

case of defaults in the underlying portfolio of assets, the first losses will be allocated to the equity

tranche according to the prioritisation. If the losses exceed the value of the equity tranche, the losses

will be allocated to the mezzanine tranche. Thus, the bigger the equity tranche, the more losses can be

absorbed by the equity tranche before the mezzanine tranche is held liable for covering the losses and

the less risky the mezzanine tranche will be. The same applies to the mezzanine and senior tranche.

The bigger the mezzanine tranche, the more losses are absorbed by the mezzanine tranche before the

senior tranche is held liable for covering the losses and the less risky the senior tranche will be. By

adjusting the prioritisation and volume of tranches it is possible to customize the risk profiles of the

tranches to a certain level.

Page 31: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

23 Master Thesis Vincent Bakker 21-03-2014

According to BIS (2008), the investors in the senior tranche are generally banks in order to diversify

their credit portfolio and supplementing their conduit financing (explained in Section 4.3). Insurance

companies and assets managers (from investments banks, hedge funds, pension funds and mutual

funds) form the largest group of investors in the mezzanine tranche (BIS, 2008). Investing in

mezzanine tranches can result in a more efficient method of gaining credit exposure than regional

corporate bond markets and is used to reduce their exposure to stock market (BIS, 2008). The equity

tranche is usually contained by the originator or speculative asset managers, active traders and

institutional investors.

Retained interest

Retained interest is the part of economic interest that is hold by the originator of the securitization

structure (ECB, 2013). Post crisis, it turned out to be of crucial importance for both regulators and

market standards. By the so called “skin in the game” or long term economic exposure in the

securitization transaction, the originator gains interest in the securitization transaction. This should

induce a better alignment between originators and investors, more concern for the quality of the asset

portfolio and better screening of obligors of underlying contracts (ECB, 2013). In general, the

originator retains a position in the equity tranche.

Post crisis, regulators have introduced “risk retention rules” that requires originators to take an

economic interest in the securitization transaction (CEBS, 2010). The EU risk retention rules are stated

in Article 122a of the Capital Requirements Directive (CEBS, 2010) and require the originator to

retain an interest of at least 5% in their own securitization transaction, based on the assumption that

this improves the screening and monitoring of borrowers and thus increase the quality of the

transaction. By the “skin in the game” originators stay exposed to a part of the credit risk of the

securitized asset portfolio.

This means that BFM has to take at least 5% of the securitization volume back. In addition, it is also

possible that the group (Schadeverzekering-Maatschappij Bovemij, SMB) takes a position in the

issued securities of the securitization transaction. In this way, it is possible to optimize the

subordination structure. However, this does have implications for the Solvency II requirements.

Solvency II is a regulatory risk-based framework for insurance companies to assess solvency

requirements. The regulation requires insurers to hold a minimum amount of capital, the solvency

capital requirement (SCR), based on the risk characteristics of assets hold on its balance sheet, which

have to be valued mark-to market (S&P, 2012b). The capital charges are depending on the risk

characteristics of the assets.

The investment in securities of a securitization transaction is considered as an investment and

classified as an asset. Solvency II requires insures to hold capital charges for securitization

investments, which are assessed in a similar way as corporate bonds (S&P, 2012b). An insurer is

required to hold an amount of capital against the assets depending on the expected loss under

unfavourable conditions. This required capital fall under the spread risk module of the SCR (S&P,

2012b). Based on the assigned credit rating to the invested tranche and the duration of the investment,

the spread risk factor can be determined and incorporated in the calculation of the SCR. The standard

formula of Solvency II can be used to determine the capital charges for securitized assets. Table 3

gives an interpretation of the used spread risk factors for different rated tranches and durations.

Page 32: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

24 Master Thesis Vincent Bakker 21-03-2014

Rating AAA AA A BBB BB B CCC and lower

Risk factor (%) 7 16 19 20 82 100 100

Maximum modified duration 6 5 4 2 1 1 1 Table 3: Spread risk factors for securitization investments (S&P, 2012b)13

When the SMB is willing to fund a part of the issued securities of the securitization transaction, this

will have implications for the capital charge of the SCR under Solvency II. Depending on the credit

rating of the tranche and duration of the securities, they have to hold a specific amount of capital under

Solvency II.

2.6.2 Excess spread

Excess spread is the most standard form of credit enhancement. Excess spread is the difference

between revenue and expenses of the SPV. It is the difference between the weighted average rate of

interest associated with the collateral and the weighted average funding costs and transaction expenses

such as servicing, trustee and professional fees (Fabozzi & Kothari, 2007; and Mezzanotte, 2013). A

positive difference can be used on a monthly base to absorb first losses in the asset pool. At the end of

the securitization it is possible that there is a positive reaming part of excess spread. This can be used

for next securitization transactions or as profit for the originator (de Coninck, 2009).

2.6.3 Reserve account

Reserve accounts are funds in which a certain amount is put for replenishing potential gaps in the

collected receivables (Mezzanotte, 2013). The amount is often deposited by the originator or liquidity

providers. These accounts are liquidity cash positions that are usually invested in high rated liquid

investments and not dependent on the performance of the collateral. The amount in the reserve account

will be used to cover unexpected losses. Reserve accounts are usually prepared at the time of issuance.

Later on, they can be supplemented by a part of the cash flow income from the collateralized asset

portfolio (de Backer, 2009).

2.6.4 Overcollateralization

Overcollateralization is an internal form of credit enhancement in which the amount of the collateral in

the securitization exceeds the total raised amount from investors (Mezzanotte, 2013). The percentage

of overcollateralization can be used to absorb losses in the collateralized asset portfolio. For instance,

if the raised capital is 100 million and the backed assets have a value of 103 million, there is an

overcollateralization of 3% which can serve as a loss buffer.

2.6.5 Monoline insurance

Monoline insurance is a form of insurance in which the issuer is guaranteed against defaults of the

asset pool. In this case a highly rated insurance company (AAA or AA rated) is paid a premium in

order to guarantee scheduled payments of principal and interest on the security in the event of a default

in the asset pool (Fabozzi, Davis, & Choudhry, 2006). The monoline insurance premium can be offset

by the lower interest rate paid to investors, due to lowered risk and higher credit rating.

2.6.6 Letter of credit

Letter of credit (LOC) is a financial guarantee committed by a bank. This type of credit enhancement

reimburses credit losses in the asset portfolio up to a predetermined amount (Fabozzi, Davis, &

13 For example, an AAA-rated securitization with 2 years duration requires a capital charge of 14%

(2*%). An AAA-rated securitization with 8 years duration requires a capital charge of 42% (6*7%).

Page 33: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

25 Master Thesis Vincent Bakker 21-03-2014

Choudhry, 2006). LOCs carry a credit rating which is the same as the issuing bank. This means that

this type of credit enhancement is only attractive with highly rated banks (Telpner, 2003). Under the

current market circumstances, this type of credit enhancement is rarely used.

In most transactions, multiple types of credit enhancements are used to improve the credit rating and

price of the securitization transaction. The order in which credit enhancement is used, depends on the

predetermined payment scheme of the securitization program, in line with the cash flow waterfall

principle of subordination.

2.7 Conclusion The objective of this chapter was to define securitization and to gain broader understanding of the

fundamentals of securitization by providing a thorough literature research. Securitization can be

defined as a structured finance technique in which a collection of unmarketable, regular and

predictable cash flow generating assets that may vary in maturity and quality, are converted into

marketable securities. These securities are issued by a legal entity (SPV) and sold to (institutional)

investors, who are repaid with interest and principal payments generated by the asset portfolio.

Securitization has the potential to bring a lot of advantages for both the originator and the investor. By

introducing securitization, it is possible for the originator to: reduce funding costs, achieve off balance

sheet funding, achieve an alternative form external funding and manage corporate risk. For BFM it is

an interest funding strategy since it has the potential to raise capital form capital markets in a cost-

effective way. Securitization enables investors to: invest in a tailor-made product, diversify investment

sources, invest in unusual investments and make investment decisions based on credit ratings provided

by rating agencies. However, there is a downside to securitization. The credit crisis in 2007 has shown

that securitization does not guarantee positive outcomes. Expected losses have been calculated

inaccurately by rating agencies. Moreover, insufficient control & understandability of the quality of

the underlying assets (mortgages) and the absence of data on the performance of the underlying assets

have resulted in incorrect credit ratings.

ABS transactions can be structured in many different ways based on the asset type and originators

motivation. However, the process of securitization of different originators or asset types shares many

similarities. For example, a number of primary roles are involved in every securitization process, but

the executing parties may differ by each securitization transaction. The process generally includes the

establishment of a special purpose vehicle (legal forms: limited partnership, limited liability company,

trust, or corporation). An SPV serves as a vehicle between originator and investors for the

transformation of illiquid assets into liquid securities and should be designed bankruptcy remote from

the originator of the assets and any other creditor. It protects investors in case of bankruptcy events of

the originator, hold the assets portfolio and issues securities with different risk profiles. Due to the fact

that the pool of assets is separated from the bankruptcy risk of the originator, it has the potential to

increase the creditworthiness of the asset portfolio and ensure much lower funding costs for the

originator.

Two of the main features of securitization are credit enhancement and credit rating. Rating agencies

play a key role in the process of securitization as they assess the creditworthiness of an entity, debt

instrument or other financial instrument. It is the job of rating agencies to bridge the asymmetric

information gap between sellers and buyers of securities and provide reliable standardized information

to the market in the form of a credit rating. A credit rating in a securitization is primary based on credit

risk, which is the risk that the obligor will default on its obligation to make periodically payments

Confidential

Page 34: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

26 Master Thesis Vincent Bakker 21-03-2014

under an agreed contract, resulting in a loss. A key input for achieving a proper credit rating is

(historical) performance and portfolio data, which are used to estimate a full probability distribution of

the expected credit loss of the pool and its variance, based on the estimates of the expected credit loss

and its variance. The costs and prices (and thus quality) of a securitization transaction are strongly

dependent on the assigned credit rating.

Credit enhancement is a method to achieve greater certainty for investors and thus better credit ratings

from rating agencies. This chapter has explained different credit enhancement methods to mitigate

several risks in the pool of assets that can improve the credit rating of the securitization. Internal credit

enhancement methods are credit protections that are obtained from the collective generating cash

flows. Main forms are subordination, excess spread, reserve account and overcollateralization.

External credit enhancement methods are credit protections that are obtained from third parties against

a certain fee. Main forms are monoline insurance and letter of credits. The alignment and final

organization of the level credit enhancement is generally done in consultation with the credit rating

agency in order to obtain a preferable credit rating. Subordination is the main form of credit

enhancement. It is generally used in all securitization transaction. BFM is required to retain a

minimum percentage of 5% of the total portfolio volume. Above that, it enables SBM to take a

position in a tranche. The right balance of interest of BFM and SBM in tranches of the securitization

can increase the quality of the most senior tranche and result in a higher rating on that tranche.

With this chapter we have answered the first research question: What is securitization? This chapter

will serve as a theoretical basis for the remainder of this report. In the next chapter we will discuss the

asset portfolio of BFM.

Page 35: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

27 Master Thesis Vincent Bakker 21-03-2014

Chapter 3: Asset portfolio identification The objective of this chapter is to examine the potential assets to be pooled in the securitization and

get a clear answer on sub question (2): What are the potential car financing assets to be securitized

and what are the characteristics of these assets? In order to determine an appropriate securitization

structure, it is important to examine the car financing assets that meet the qualifying definition

mentioned in Section 2.1 (the asset must generate a regular and predictable cash flow, and may differ

in maturity and quality). An important factor in securitization transactions is the volume of the asset

portfolio. Moreover, the finance company just started their business and is expected to grow

significantly. It is not only important to determine the exact type and structure of the car financing

assets, but also to examine the expected growth and development of the portfolio.

In the first section of this chapter we examine the characteristics of the (current) financial assets.

Different customer types contain different contract structures, which may lead to different

characteristics in the financial assets. Then, we investigate the expected development of the finance

company for the next 5 years. This will be divided into extension of the current asset types and

possible expansion of asset types in the future. Next, we determine the differences in dealing of

different asset types in the securitization transaction and the asset requirements.

3.1 Financial asset types The majority of the invested amount is composed of financial contracts to customers (BOVAG

enterprises), who in turn enter into contracts with end customers; business customers of BOVAG

enterprises. A small part is directly provided to end customers. C4L distinguishes 4 different types of

customers:

Management & funding customer

(Solely) Funding customer

Label lease customer

(Solely) Management customer

In case of (solely) management customer, neither BFM nor C4L will be the funder of the contract.

This type of customer is supported by C4L with their administration and management of leasing

activities. These agreements contain no funding contract and are not suitable for securitization

purposes of BFM and C4L. The other customer types do contain a financing contract. In the following

sections we will explain the other three customer types and corresponding contract structure in more

detail in order to examine their suitability for securitization purposes.

3.1.1 Management & funding customer

C4L provides the ability for management & funding customers (BOVAG enterprises) to start up or

continue its own leasing company. By creating an own administration of the leasing company inside

C4L, it is possible to manage and control the leasing company of the customer. In addition, C4L/BFM

provides the funding of the contract. This enables BOVAG enterprises with a potential portfolio of

100 lease cars or more to conduct its own leasing company in an efficient way. The lease department

of a BOVAG enterprise can close its lease contracts independently with its customers and outsource

the administration & funding of the contracts through C4L.

Figure 10 explains the contract structure and ownership of management & funding customers. The

leasing company of the BOVAG enterprise independently closes a lease contract with the end

customer. These contracts with end customers are mainly (net) operational lease contracts in which the

end customer has agreed to pay periodic lease instalments in exchange for the usage of the car for the

Confidential

Page 36: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

28 Master Thesis Vincent Bakker 21-03-2014

agreed period. However, BOVAG enterprises do not have sufficient capital to finance the underlying

car. In order to finance the car, the BOVAG enterprise enters into a lease contract with C4L. C4L

purchases the car and then leases the car to the BOVAG enterprise through a net operational lease

contract. In addition, a redemption statement is closed on top of the net operational lease contract,

which guarantees the final lease instalment and sale of the car at the end of the lease term. The

combination of a net operational lease contract and a redemption statement ensures that the contract

becomes a financial lease contract. In addition, a third clause is established on the contract between

customer and end customers. In the case that the leasing company does not fulfil its obligations to

C4L, the finance company is able to take over the operational lease contract with the end customer.

Figure 10: Contract structure and ownership characteristics of management & funding customers of C4L

C4L becomes the lessor and thus the legal owner of the underlying asset in the financial lease contract.

As the legal owner, C4L activates a financial lease contract as an asset on its balance. At the end of the

lease term, the legal ownership is transferred to leasing company by the redemption statement. The

BOVAG enterprise is the lessee of the financial lease contract and becomes the economic owner of the

underlying assets. This ensures that the BOVAG enterprise is in control of the assets (car). The

BOVAG enterprise is exposed to risks and benefits of economic ownership of the underlying asset and

must activate the asset on its balance, which is financed by a financial lease contract (liability).

The BOVAG enterprise is the legal and economic owner (lessor) of the underlying asset in the

operational lease contract with the end customer (lessee), and thus responsible for maintenance and

risk of the asset. However, the ultimate legal ownership is with the finance company, due to a master

agreement on the financial lease and operational lease contract. The lessor only transfers the right of

using the asset to the lessee. At the end of the contract term, the lessee returns the asset to the lessor.

The BOVAG enterprise therefore activates an operational lease contract on its balance. Even though

C4L is not the direct lessor to the end customer, all data, processes and payment behaviour are

monitored by C4L, because the contracts between BOVAG leasing company and end customer are

controlled and managed by C4L.

3.1.2 Funding customer

Funding customers are larger leasing companies who execute the management and administration of

the lease activities on their own. The situation is the same as explained in Section 3.1.1, where the

leasing company closes the lease contract with the end customer and finances this with an operational

lease contract and redemption statement on the car. This results in a financial lease contract for C4L.

However, C4L is only the funder of the lease contracts and does not control the management and

administration of the contracts between the leasing company and end customers. Thereby, C4L has

Confidential

Confidential

Page 37: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

29 Master Thesis Vincent Bakker 21-03-2014

less insight in data, processes and payment behaviour of the end customers. This makes it hard to

monitor the performance of the total performance of the contract structure.

3.1.3 Label lease customer

Label lease provides an opportunity for smaller car companies (with a potential of less than 100 lease

contracts) to close lease contracts with end customers. For smaller car companies it is not easy to

undertake leasing activities under its own label. It is often impossible to efficiently organize the

administration, management and funding of lease activities and operations. Label lease allows

BOVAG enterprises to propose a lease offer to its end customers and then transfer the offer to C4L

who will execute the contract on behalf of the car company. This enables BOVAG enterprises to

extend their product range with lease possibilities.

Figure 11 explains the situation of label lease. Label lease is a form of vendor lease. In vendor lease a

third party (the vendor) is involved in the establishment of a lease contract. The BOVAG enterprise

makes a proposal of a lease contract to the end customers. This proposal is then accepted and executed

by C4L. In fact, the end customer is entering into a lease contract with C4L that is arranged by the

BOVAG enterprise, who becomes the vendor of the lease contract. The contracts with end customers

are mainly (net) operational lease contracts in which the customer has agreed to pay periodic lease

instalments. On top of the operational lease contract with an end customer, the BOVAG enterprise

signs a redemption statement with C4L on the leased car. This guarantees the repurchase of the car by

the car company at the end of the lease term. Eventually losses on the residual value of the car are for

the account of the BOVAG enterprise.

Figure 11: Contract structure an ownership characteristics of label lease customers of C4L

C4L becomes the lessor and is the legal and economic owner of the asset in the (net) operational lease

contract with the customer. The lessor only transfers the right of using the asset to the lessee. C4L is

exposed to the risk and benefits of economic ownership during the contract. However, eventually

losses on the residual value of the car are for the account of the BOVAG enterprise, thanks to the

coupled redemption statement.

In the case of label lease, the contracts are fully managed and owned by C4L. Thereby, C4L has full

insight into all data, processes and payment behaviour of end customers related to the contracts.

3.2 Current portfolio BFM has invested a total of approximately 25 million in car financings via C4L. The financial asset

portfolio of BFM consists of two types of lease contracts, operational lease and financial lease. The

contracts have a couple of similarities and differences which may affect the structure determination of

the securitization. Both types results in a financial contract (the asset) that produce regular and

Confidential

Confidential

Page 38: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

30 Master Thesis Vincent Bakker 21-03-2014

predictable cash flows for the term of the contract with a car as collateral, whereby both type of

contracts may be eligible for securitization purposes.

In total, 1440 contracts are established through 17 leasing companies (or customers). In turn, they have

signed contracts with 614 different lessees, by which the average number of contracts per lessee is

2,35 contracts (Remark: 39 end customers are unknown). The different types of customers and their

contracts can be summarized in one figure. The portfolio contract structure to the end customers is

displayed in Figure 12, where LC is a lease company or customer of BFM and EC the end customer of

the leasing company.

Figure 12: Summary of portfolio contract structure

An analysis of the current portfolio14

of car related finances showed that the portfolio represents an

initial value of approximately €25,3 million (see Table 4). The current book value of the total

outstanding investments in car related financings can be calculated by subtracting the repayments

(already paid lease amortization instalments) from the initial value and equals to approximately €23,5

million. The numbers show that approximately 53% of the amount exists of lease instalments

receivables and the other 47% is related to receivables from redemption payments. The weighted

average contract funding rate is 4,47%.

Table 4: Contract numbers and volume figures of portfolio

At the moment, the capital capacity of €100 million is more than sufficient in order to finance the

current portfolio15

. However, these figures are not yet very representative for securitization, because

the portfolio is not yet fully developed. This can be explained by the following. Current contracts have

a weighted average original term of 33,1 months. The weighted average remaining term is 28,4

14 From the monthly report of September

15 See Appendix 3 for an overview of the current funding balance

Contracts Number

Total number of contracts 1440

Direct customers( BOVAG enterprises) 17

End customers (Lessees) 614

(unknown) 39

Number of contracts per lessee (known) 2,35

Volume Total Per contract Percentage

Inital financing amount 25.319.412,58€ 17.582,93€

Repayments 1.831.317,99€ 1.271,75€

Book value 23.488.094,59€ 16.311,18€

Percentage leasing instalments 13.521.131,34€ 9.389,67€ 53,40%

Percentage redemption payment 11.798.281,24€ 8.193,25€ 46,60%

Confidential

Page 39: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

31 Master Thesis Vincent Bakker 21-03-2014

months. This means that the average elapsed contract term or seasoning is 4,7 months (33,1-28,4).

Moreover, most contracts do not expire for the time being. Therefore, the next period (2 years) mainly

new customers will enter into contracts while there are almost no expirations in the portfolio. A

substantial growth of the asset portfolio may be expected in the next few years. Moreover, a remark

should be made on the figures, because a small number of the contracts are used as rentals by the

customers. They have a shorter maturity than lease-based contracts end therefore a higher final

instalment. It is for that reason possible that the composition of the portfolio will change during the

next years towards a composition of longer original terms and lower final instalments.

3.3 Portfolio development The customer base and asset portfolio of BFM/C4L is expected to grow significantly in the next years.

This is important for the determination of a strategy towards performing a securitization program. It is

possible that the portfolio will be expanded with financings aimed at private end customers (private

lease, hire-purchase or consumer credit). In particular, the role of BFD/BF is of importance with a

view to a possible securitization strategy. In this section, we determine the expected growth of the

asset portfolio and the possible expansion of the asset types of BFM.

3.3.1 Future portfolio growth

The current outstanding amount of lease contracts provides no capital problems. However, the

expectation is that the total amount of outstanding financings will significantly increase in the next

years, even more than the current maximum capital capacity. The expected growth of the financial

asset portfolio is displayed in contract numbers in Table 516

.

Table 5: Expected outstanding number of contracts and number of customers up to and including 2018.

These expected contract numbers show that most part of the contracts will consists of management &

funding; and funding customers in the future. The assets related to this type of customers are financial

lease contracts. Label lease is not expected to be as large as the other two customer types. In 2018, the

expected proportion of financial lease contracts in the portfolio is around 94,5%

((6100+7500)/14100*100%). The proportion of operational lease contracts is 5.5%.

Based on these expectations, we have translated the contract numbers into an expected total volume of

the asset portfolio for the corresponding years in Table 5. Therefore, we have made the following

assumptions:

Contracts have an average initial financing value of €15.000 (which is conservative compared

to €17.582,92 which is the current initial average financing value of the contracts)

16 Based on expectations from the management

Expected number of contracts 2013 2014 2015 2016 2017 2018

Label lease 250 300 350 400 450 500

Management & funding 1.100 1.600 2.725 3.850 4.975 6.100

Funding 0 1.500 3.000 4.500 6.000 7.500

Total number of outstanding contracts 1.350 3.400 6.075 8.750 11.425 14.100

Expected number of customers 2.013 2.014 2.015 2.016 2.017 2.018

Label lease 8 10 12 13 15 17

Management & funding 7 11 18 26 33 41

Only funding 0 6 12 18 24 30

Confidential

Page 40: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

32 Master Thesis Vincent Bakker 21-03-2014

Average original lease term of 3 years (which approximately come close to the current

average original term of 33,1 months).

The percentage of redemption payment is set at 45% (which is comparable to the current

percentage).

Table 6: Total estimated portfolio amount of the car financing portfolio up to and including 2018

The total initial financing amount is expected to grow towards € 211.500.000 in 2018 (14.100 *

€15.000) as displayed in Table 5. The total book value is calculated by the value of new contracts, plus

the value of 1 year old contracts, plus the value of 2 year old contracts. The calculations take into

account that contracts expire after three years and should be reissued after three years17

. The numbers

of new contracts are displayed in the row “of which new contracts”. In 2018, the expected total book

value of the portfolio is about €176 million. At the moment, the finance company has a maximum

capital capacity of €100 million. With the current expectations this can cause capital shortage

problems in 2015 and later.

3.3.2 Future portfolio expansion

It is possible that the finance company will expand its financial services with other types of financial

products or contracts. This can result in other asset types than car related financial lease and

operational lease contracts. A potential new market is the private leasing market. It is possible that

BFM wants to support its customers to offer private lease products. These are expected to be

structured in the same way as management and funding customers (Section 3.1.1), but with a private

end customer instead of a business customer.

The financial services of business unit BFD/BF are of also of important interest for this study. A part

of the financial services of BFD/BF are focussed on car related financings. As already mentioned in

the introduction of this report, they mediate in car related financings for corporate and private end

customers. They are an intermediary in the area of car related consumer loan; hire purchase and

financial lease products.

In the future, it seems obvious that BFD/BF will co-operate with BFM and transfer their financial

products in the finance company of the group. The portfolio of BFD/BF may then be incorporated in

the securitization transaction. However, their financial products are different from the products that

BFM currently offer. They are focussed on hire purchase and consumer loans to end customers. The

treatment of hire purchase or consumer loans in securitization transactions can be slightly different

from other types of financial products. Besides that, the products are offered to private customers,

which can also affect securitization transactions. But it can also improve the diversification of the

securitization asset portfolio and thus improve the quality of the transaction.

17 See Appendix 6 for the explanation of the calculations

Expected portfolio volume 2.013 2.014 2.015 2.016 2.017 2.018

Total number of outstanding contracts 1.350 3.400 6.075 8.750 11.425 14.100

of which new contracts 1.350 2.050 2.675 4.025 4.725 5.350

Initial financing amount 20.250.000€ 51.000.000€ 91.125.000€ 131.250.000€ 171.375.000€ 211.500.000€

Value new contracts 20.250.000€ 30.750.000€ 40.125.000€ 60.375.000€ 70.875.000€ 80.250.000€

Value of 1year-old contracts 16.537.500€ 25.112.500€ 32.768.750€ 49.306.250€ 57.881.250€

Value of 2year-old contracts 12.825.000€ 19.475.000€ 25.412.500€ 38.237.500€

Total book value 20.250.000€ 47.287.500€ 78.062.500€ 112.618.750€ 145.593.750€ 176.368.750€

Confidential

Page 41: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

33 Master Thesis Vincent Bakker 21-03-2014

3.4 True sale & titling transfer

In this research, we are particularly focussed on the growth of the current asset types of BFM. The

possible future expansion with the portfolio of financial products offered by BFD/BF is included as a

boundary condition for the outcome of the results of this research. The various contracts and customer

types are summarized in Table 7.

Current contract types Customer

Financial lease contracts Business customer, lease company

Operational lease contracts Business customer

Potential contract types Customer

Operational lease contracts (Private lease) Private customer

Consumer loan (car related) Private customer

Hire-purchase Private customer Table 7: Current and potential contracts for securitization

All contracts are car related contracts that produce a regular and predictable cash flow stream with a

similar asset as collateral. Credit rating agencies have a list of requirements which must be satisfied in

order to obtain a credit rating on the securitization transaction of lease related assets (Fitch, 2011; and

Moody‟s, 2011). Eligibility criteria for leases to be included in a securitization are:

At lease the first payment must be made (1 month seasoning)

No receivables more than 30 days or 60 days past (no delinquency)

No lessee can be in a bankruptcy procedure

The lease is assignable

The assets that meet these requirements can be included in the asset portfolio to be securitized. In

addition, a number of legal issues must be met, but these are covered in Section 5.6.3.

An important point of attention in car lease securitizations is the assignment of a true sale transaction,

when the assets are considered to be securitized. In all cases, the legal ownership must be isolated

from the originator and no claims may be made on the asset by any creditor in case of a bankruptcy

procedure of the originator. The legal title must be transferred to the SPV, in order to ensure that the

SPV becomes legal owner of the underlying asset.

The difference between the financial contracts deals particularly about the economic ownership of the

underlying asset. An important characteristic of a financial lease is that the economic ownership of the

underlying asset (car) lies not with C4L. As a result, the car is not activated on the balance of the

finance company. It is only possible to securitize the final installment generated by the financial lease

contracts by selling the rights over those receivables to the SPV. Because the customer has accepted a

redemption statement, he is obliged to pay the predetermined final installment in exchange for the

legal ownership of the car at the end of the lease term. In order to securitize the final installment, the

rights of the redemption statement must be transferred to the SPV.

In the case of operational lease, the underlying asset should also be transferred to the SPV in order to

ensure that the economic ownership will be placed in the SPV. Thereby, the residual value is isolated

from the originator of the lease contract. In this case, both the contract and the underlying assets (car)

are sold to the SPV.

The operations to achieve a true sale transaction or retitling of the assets can require much effort and

expenses (Litwin & Levy, 2000). It may be useful to introduce a titling trust before starting a

Confidential

Confidential

Page 42: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

34 Master Thesis Vincent Bakker 21-03-2014

securitization transaction. The titling trust (established by the originator) is intended to be bankruptcy

remote from the originator (Moody‟s, 2011). In the pre-securitization phase, a titling trust can be used

to hold the vehicle title and leases from the beginning of the underwritten lease contract. The

originator is never listed on any title, but has an undivided beneficial interest (UTI) in all leases and

related vehicles (Fitch, 2007; and Litwin & Levy, 2000). The originator is contractually engaged as a

servicer of the titling trust.

When a securitization actually takes place, the titling trust will issue certificates that represent a

special unit of beneficial interest (SUBI) on the assets to be securitized (Fitch,2007), which are sold

(true sale) to the securitization trust or SPV. No transfer of titles is needed and the vehicle ownership

and lease contracts remain with the titling trust. Only the SUBI certificates and the associated rights

are transferred to the securitization SPV (Fitch,2007).

3.5 Conclusion The objective of this chapter was to identify the potential assets of BFM/ C4L that are eligible for

securitization possibilities. The asset portfolio of BFM/C4L exists of financial lease and operational

lease contracts that are provided to three types of customers. The three customer types are label lease,

funding & management and funding customers. These customers enter into lease contracts with

(business) end customers which are one to one linked to the lease contracts with the finance company.

On top of the lease contracts, the customer has entered into a redemption agreement to repurchase the

car from C4L/BFM for a predetermined final payment at the end of the lease term. This guarantees the

transfer of legal ownership at the end of the lease term. Moreover, there is a third clause in which the

finance company has the right to take over the lease contracts between customers and end customers in

case that the customer is not able to meet its obligations.

An important point of attention in car lease securitizations is the assignment of a true sale transaction

when the assets are considered to be securitized. Although there are small structural differences

between customer types, both financial lease and operational lease contracts generate a predictable and

regular cash flow. The receivables of the financial assets can be separated into periodic lease

instalments and a final payment (based on redemption agreement). The legal title of the contracts must

be transferred (to achieve a true sale transaction) towards the SPV in order to ensure that the legal

ownership is isolated from the originator and no claims can be made on the asset by any creditor in

case of a bankruptcy procedure of the originator.

The difference between financial lease and operational lease contracts is the economic ownership of

the underlying car. In financial lease contracts, it is only possible to securitize the final installment

generated by the financial lease contracts by selling the rights over those receivables to the SPV. This

can be done by transferring the redemption statement and its rights to the SPV. In operational lease,

the underlying assets (car) must also be sold to the SPV in order to isolate the residual value

realization from the originator. However, these retitling issues require effort and expense. Therefore, it

can be useful to introduce a titling trust before starting a securitization transaction, in which the

vehicle title and leases from the beginning of the underwritten lease contract. Thereby, no titling

transferring is needed when a securitization transaction is introduced, which may save effort and

expenses.

In Chapter 1, we already mentioned the importance of data that is required by rating agencies. It turns

out that BFM/C4L has no visibility into all relevant data of the characteristics and payment

performance data of end customers. In the case of label lease and management & funding customers,

all data can be acquired, because all processes are managed by BFM. However, funding customers

Confidential

Page 43: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

35 Master Thesis Vincent Bakker 21-03-2014

manage their leasing activities on their own. For the acquisition of data, the finance company is

dependent on the customer.

The portfolio of BFM/C4L is expected to grow above the current capital capacity of € 100 million

(15% equity, 25% internal debt, 60% external debt), in which 94,5% represent a financial lease

contract and 5.5% a operation lease contract. This means that additional capital is required to continue

the financing business when the portfolio volume exceeds €100 million. Moreover, it is possible that

the portfolio is expanded with a part of the car related financings of the BFD/BF business unit within

the BVG. This emphasizes the need for more capital.

With this chapter we have answered the second research question: What are the potential car

financing assets to be securitized and what are the characteristics of these assets? In the next chapter

we will determine what type of securitization structure best fits the potential assets portfolio and

motivation & needs of BFM/C4L.

Confidential

Page 44: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

36 Master Thesis Vincent Bakker 21-03-2014

Chapter 4: Securitization structure decision The objective of this chapter is to examine what type(s) of securitization structure(s) best suits to the

considered asset portfolio, motivation and need of the finance company. As already mentioned in

Chapter 2, raising capital is the most important motivation to perform a securitization transaction for

BFM. A true sale securitization can achieve that objective. However, a true sale ABS can be organised

in several ways. Initially, we focused this research on self-contained securitization programs that are

specifically organized for one originator, in which capital is raised from capital markets solely based

on the asset portfolio of the finance company. But, participating in an ABCP securitization structure

may also be interesting for BFM. Therefore we examine both.

According to Sabarwal, (2006) and Tavakoli (2008), four common true sale ABS structures are:

Master trust structure

Owner trust structure

Grantor trust structure

Asset-Backed Commercial Paper (ABCP)

These four structures are very similar to the typical true sale securitization structure as defined in

Chapter 2. There are a number of structure specific features that make them differ from one another.

In the first sections, we will define the four ABS structures. We will start with the three self-

containing securitization structures and then explain ABCP. We explain the main features of the

structures. Thereafter, we develop an assessment model with three criteria in order to determine which

structure is most suitable for the finance company. This enables us to answer research question (3):

Which ABS structure is most suitable to BFM for the organization of the securitization of the asset

portfolio of the finance company?

4.1 Master trust structure

A master trust structure is structured as explained in Section 2.3 and can be used for the securitization

of either short-term or long-term assets. This securitization structure is a self-contained structure in

which the transaction is specifically organized for one originator. The SPV is characterized by a

master trust. The master trust issues series of investor certificates and seller certificates with a

medium to long term maturity (over one year) (Fabozzi & Choudhry, 2004). The originator is

expected to retain a percentage of the principal in the certificates which is called seller‟s interest in the

asset portfolio. The seller‟s interest is primary used to absorb daily fluctuations in the amount of

receivables of the trust, arising from many factors, such as delinquent payments and early termination

(Fabozzi & Choudhry, 2004). In addition, seller‟s interest provides more alignment between the

originator and investors, because the originator would also benefit from a well serviced transaction.

The investor‟s certificates give investors an undivided beneficial interest in the asset portfolio of the

issuing trust (Sabarwal, 2006). These may be divided into several asset classes with different seniority.

The main feature of a master trust structure is that the trust has the possibility to issue multiple series

of securities from the same trust on an on-going basis. Each additional series of securities will be

backed by the whole asset portfolio and not only by the added part of the portfolio (Tavakoli, 2008).

The master trust structure is a very flexible securitization structure, due to the possibility of issuing

new series of certificates can be done from the same master trust structure. New portfolios can easily

be added to the existing transaction, so that it is not necessary to organise a new transaction. Thereby,

it can save costs and effort.

Page 45: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

37 Master Thesis Vincent Bakker 21-03-2014

Issuance of new series changes the characteristics of the underlying portfolio. This means that the

composition and performance of the securitized asset pool can change during de term of the

transaction. Moreover, new series can differ in size, maturity, credit rating and interest rate (Tavakoli,

2008). Every series has an expected final payment date and a legal termination date. At the expected

final payment date, the investors are expected to receive the last principal payment. After the legal

termination date, investors have no rights to any additional cash flow. Despite the differences between

issued series, they are all covered by the entire portfolio and have to meet predetermined requirements

of the credit rating agency. Each additional issued series has to be assessed by the rating agent. The

master structure allows originators to choose a cash flow structure to repay the investors in securities.

This can be divided into the following structures:

Pass-through

Pay-through

4.1.1 Pass-through

A pass-through structure is a cash flow structure to repay principal investments to investors. These are

sometimes also called amortizing transactions, uncontrolled amortization or fast pay structure (Fabozzi

& Choudhry, 2004; and Tavakoli, 2008). In pass-through structured ABS, the originator sells a

portfolio of assets via a true sale to an SPV. The main feature of a pass-through structure is the way of

repayment of interest and principal to investors. Investors that invest in a pass-through ABS take a

direct exposure on the performance of the asset portfolio in the securitization (Fabozzi & Choudhry,

2004). They actually invest in pass-through certificates issued by the SPV. They obtain a share of

ownership in the underlying cash flow generating asset portfolio.

The repayment of principal and interest is passed-through (or returned) to investors during the lifetime

of the securitization transaction to repay the initial invested amount and interest. This is depending on

the performance of the asset portfolio. The pass-through structure is particularly applicable for assets

with longer maturities and assets with interest and principal payments that depend on the amortization

schedule (see Figure 13). In the early periods, most of the repayment is allocated to the interest instead

of the principal. Later on, most of the repayment is allocated to the principal instead of interest. The

proceeds from the asset portfolio are collected by the servicer and passed through to investors. In the

event of shortcomings or late payments in the securitized asset portfolio, payments to investors are (to

some extend) covered by credit enhancements.

Figure 13: Pass-through or amortization structure (Source: Fabozzi, & Choudhry, 2004).

4.1.2 Pay-through

In a pay-through structure, the originator sells a portfolio of assets via a true sale to an SPV just as in

the case of a pass-through structure. However, a pay-through structure is somewhat different than a

pass-through structure. The main feature of a pay-through ABS is that it is a borrowing structure and

Page 46: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

38 Master Thesis Vincent Bakker 21-03-2014

not participation (Tavakoli, 2008). Investors do not directly own the underlying assets, but are only

invested into a bond backed by these assets. This enables issuing entities to de-synchronize or to

manipulate the cash flows into separate cash payment streams (Fabozzi & Choudhry, 2004). Thereby,

it is possible to reconstruct the repayment of cash flows to investors into different levels of debt.

A pay-through structure, sometimes also called a revolving transaction, is often used for assets with

short term maturities (between 60-120 days) and is divided into two periods, namely the revolving

period and the controlled amortization period (Sabarwal, 2006). In the revolving period, the only

payments made to investors are interest payments. The other proceeds received from the securitized

asset pool are used to service and maintain the securitization, by paying servicing fees and purchasing

new assets. This structure ensures a predictable payment stream for investors.

Pay-through structures have a predetermined legal end date. Investors are expected to receive all of

their principal back before the legal end date of the securities. Principal investments are paid back to

investors during the controlled amortization period or pay-out period. Fabozzi & Choudhry (2004);

and Tavakoli (2008) distinguish two different forms how the principal can be returned to investors

during the controlled amortization period by soft or hard bullets. When the structure is structured with

a hard bullet, the principal is stored in a reserve account during a certain period (the controlled

amortization period) and paid back in one payment to the investors through a hard (single) bullet

payment. The soft bullet repayment starts earlier paying back the principal. Instead of depositing the

principals into a reserve account, they are paid in several instalments during the controlled

amortization period (generally 1 to 3 years). The pay-through structure is displayed by an example in

Figure 14.

Figure 14: Pay-through or revolving structure with soft bullet (grey) and hard bullet (black) controlled amortization

period (Source: Fabozzi, & Choudhry, 2004)

Both pass-through and pay-through structures can be combined into a hybrid structure. In a hybrid

structure can be chosen for a short revolving period (for generally 0-2 years), followed by a pass-

through structure (Fabozzi & Choudhry, 2004). The revolving period can be used to optimize the asset

portfolio in the first two years. The hybrid structure is often used for medium to long term assets.

4.2 Grantor & owner trust structure Grantor and owner trust structures are a type of pass-through securitization structures and are

organized as explained and displayed in Section 2.3. These securitization structures are self-contained

structures in which the transaction is specifically organized for one originator. In grantor and owner

trusts, an originators pools together a portfolio of assets and sell them off by a true sale to an (grantor

or owner trust) SPV. The SPV issues (long term) pass-through certificates to investors in order to

Page 47: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

39 Master Thesis Vincent Bakker 21-03-2014

finance the purchase of the asset portfolio. Thereby, the investors in the certificates obtain a direct

share of ownership in the receivables. These securitization structures are standalone securitization

structures. This means that the structure can be used once for the securitization of a portfolio of assets

and cannot be reused for the issuance of new securities. The repayment structures are corresponding to

the pass-through structure as explained in Section 4.1.1.

In case of a grantor trust, interest and principal generated by the asset portfolio is passed-through in

proportions to the holder of the certificates after subtraction of several servicing fees and expenses of

the securitization transaction. This structure can provide little flexibility by subordinated classes of

securities, but only the interest part of subordinated classes can be used to absorb losses of senior

tranches (Sabarwal, 2006). Grantor trusts have a limited ability to reinvest cash flows and purchase

additional asset, making them less suitable for short-term assets (such as credit cards) (Tavakoli,

2008). This tranching repayment is displayed in Figure 15.

Figure 15: Grantor (left) and owner trust (right) amortization structures (Fabozzi, 2000).

The owner trust structure allows more flexibility in structuring the cash flows, due to a more flexible

seniority time-tranching (Sabarwal, 2006; and Tavakoli, 2008). Time-tranching allows the issuer to

create different security tranches on a tailor-made basis to suit investor preferences (Fabozzi, 2000). In

owner trusts, cash flows generated by the asset portfolio can be allocated to the different classes of

issued securities in terms of interest, principal and maturity (Sabarwal, 2006; and Tavakoli, 2008).

This means that both interest and principal of subordinated tranches can be used to absorb losses of the

senior tranche. This allows originators to adapt the profiles in terms of risk and return profile of issued

security tranches. The owner trust (as well as the grantor trust) can be used for the securitization of

medium to long-term assets (Tavakoli, 2008). The owner trust is displayed in Figure 15, shows how

the principal is repaid to investors. The first tranche (A1) is paid back fully before other tranches get

paid. Then, the second tranche (A2) is paid back fully before others get paid. This subordination

follows the cash flow waterfall principle as explained in Section 2.6.1.

4.3 Asset-backed commercial paper (conduit) Asset-backed commercial paper (ABCP) is a form of short term senior secured debt by issuing

commercial papers (CP) through a conduit, which are backed by a pool of short or long term

(financial) assets (Blackrock, 2011; and Moody‟s, 2003). ABCP structures are particularly used to

acquire (short term) low-cost, off balance sheet funding. Just as in the case of the other ABS structures

described in this section, the assets of the originator are sold to an SPV as a true sale transaction.

ABCP programs itself have no maturity and are intended to be perpetual.

4.3.1 Basic mechanism

The SPV in an ABCP is usually called a conduit or ABCP conduit, because it reflects its function as a

collector and payer of cash receipts and payments (Blackrock, 2011; and Fabozzi & Choudhry, 2004).

The conduit is the issuer of commercial papers (CP) and uses the proceeds from CP to fund an

Page 48: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

40 Master Thesis Vincent Bakker 21-03-2014

originators portfolio of cash flow generating assets that meet the definition in Section 2.1. These CP

have a maturity range from 1 up to 365 days and often have a shorter term than the backed assets

(DBRS, 2013). The actual maturity of CP depends on the kind of assets to be securitized (Covitz,

Liang, & Suarez, 2009). Originators have the possibility to securitize a wide range of assets in terms of

(long and short) maturity and type (for example credit card receivables, auto-backed assets and

mortgages receivables). A pool of cash flow generating assets from a single type or group of various

asset classes can be securitized in the ABCP transaction (Blackrock, 2011). The conduit‟s legal

structure is often classified as a regulated investment company (RIC). However, it may take various

legal forms like trusts, corporations and limited partnerships, as long as it is legally structured as

bankruptcy remote as possible (Fitch, 2012; and Gorton & Souleles, 2003). It is not owned or

consolidated with the sponsor (bank) of the conduits.

In ABCP, the proceeds generated by the asset portfolio(s) are used for the payment of interest &

principal to investors and maintenance of the conduit‟s investments (Fitch, 2001). In general, interest

proceeds from the asset portfolio cover the interest payment to investors and conduit fees. The

amortization income of the backed asset portfolio is generally used to maintain the conduit and

repurchase of new assets in the conduit. As a result, the value of the conduit remains around a certain

value. At expiration of CP, (current) investors will be repaid or rolled over with new issued CP in

order to cover the initial deposit. This process is called “rolling the CP” and enables the conduit to

continue additional issuances of commercial paper, which enables originators to fund long-term assets

on a continuing basis with short term debt (DBRS, 2013; and Moody‟s, 2003).

4.3.2 Conduit types in ABCP

ABCP are subdivided into securities arbitrage conduits, trade receivables conduits and hybrid conduits

(Fabozzi & Choudhry, 2004). Securities arbitrage conduits are exclusively used to generate revenues

from arbitrage gains between security investments (ABS, MBS and government bonds) and highly

rated paper that is used to fund these assets. Trade receivables conduits are used to provide funding for

cash flow generating asset portfolios. Hybrid conduits take a form of both securities and trade

receivables conduits.

ABCP can be carried out by one or more originators and multiple asset portfolios depending on the

type of assets and securitization motivation (Covitz, Liang, & Suarez, 2009; Fabozzi & Choudhry,

2004; and Moody‟s, 2003). The ABCP is called a multi-seller ABCP if multiple originators are

involved in the securitization transaction. The ABCP is called single-seller ABCP if one originator is

involved in the securitization transaction.

A multi-seller ABCP structure involves the purchase of multiple portfolios of assets from various

unaffiliated originators from a wide variety of industries, companies and asset types (Moody‟s, 2003;

and Tavakoli, 2008). Conduits of multi-seller structures are established, administrated and sponsored

by large commercial banks (Fabozzi & Choudhry, 2004). These banks serve as the program

administrator or sponsor of the conduit and often provide credit enhancement and liquidity support to

the securitisation transaction (Fitch, 2001). In multi-seller structures, the CPs have a claim against the

entire pool of asset portfolio‟s funded by the conduit (Tavakoli, 2008). The multi-seller structure is

displayed in Figure 16.

Page 49: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

41 Master Thesis Vincent Bakker 21-03-2014

Figure 16: Multi-seller ABCP structure

In a multi-seller ABCP, separate SPVs are established for each involved originator in the transaction

with the aim of owning the asset portfolio. Assets portfolios are purchased via a true sale from

originators by the corresponding deal-specific SPV. The SPVs are financed by the conduit on a

borrowing base. In fact, the conduit takes a first priority perfected security interest in the SPV, which

means that the conduit is the first in the order of priority in allocating receivables from asset portfolios.

Thereby, the conduit receives the senior interest in the asset portfolio of the SPV. The conduit issues

CP in order to attract money from investors. The proceeds from CP are used to fund the SPVs. This

structure is called a two-tier legal structure (Fitch, 2001). This is displayed in Figure 17 which

explains the dotted line of Figure 16 in more detail.

Figure 17: Two-tier legal structure in ABCP

The two-tier structure can be divided in a deal-specific and program-wide part. Deal-specific refers to

the transaction specific part of one originator in the transaction. Every deal-specific transaction is

usually structured in the same way as a term ABS, in which it has its own intermediate deal-specific

SPV that holds the assets (see Figure 5). Program-wide refers to the whole conduit structure and all

involved originators. Each added transaction or added portfolio of an originator must be structured in

line with the program-wide risk profile and CP rating.

The conduit sponsor is the administrator of the conduit and is responsible for the management and

continuity of the conduit. The liquidity provider of the conduit is a third party that provides liquidity

when needed. The credit enhancement (CE) provider of the conduit is the third party that provides

credit enhancement on program-wide basis. These parties request an additional fee for their

contribution to the securitization transaction.

Page 50: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

42 Master Thesis Vincent Bakker 21-03-2014

Any transaction or portfolio of an originator funded by the conduit has to have a deal-specific first loss

protection depending on the quality of the portfolio (Moody‟s, 2003). This first loss position is often

retained by the originator as a percentage of the total deal-specific volume. ABCP can profit from a

two-layered credit enhancement structure. Deal-specific credit enhancement can improve the credit

risk of a specific portfolio of an originator. Deal-specific credit enhancement can only cover the losses

belonging to the specific-deal originator and cannot be used to cover losses in other deal-specific pools

(S&P, 2005). The level of deal specific credit enhancement must be commensurate with the rating of

the ABCP to be issued, in order to ensure that the deal specific transactions are funded largely

independent (GCRC, 2013). In addition, a program-wide credit enhancement is used to improve the

overall risk of the conduit and is arranged by the conduit sponsor. This program-wide credit

enhancement is used to cover extraordinary losses in excess of deal-specific credit enhancement.

A single-seller ABCP structure involves the purchase of cash flow generating assets from one

originator. In single-seller structures, the originator uses a conduit as a source of funding for its own

businesses. The assets are usually sold to an SPV by a true sale. The conduit is the issuer of

commercial paper and lends the proceeds from CP to the SPV. The structure of a single-seller conduit

is displayed in Figure 18.

Figure 18: Single-seller ABCP structure

Single-seller ABCP structures are mainly interesting for originators with a very large portfolio volume

and different type of asset classes (Tavakoli, 2008). While originators in single-seller ABCP have the

advantage of significant control over the costs of administrating the conduit, they also contribute to the

costs alone and need very large volumes to cover these costs. Therefore, they are not interesting as a

funding solution for the finance company in the foreseeable future. In the remainder of this report we

focus on the participation in a multi-seller ABCP structure as a funding solution for the finance

company.

4.3.3 Support mechanisms

A key feature of ABCP is the support that is provided to the ABCP program. The support mechanisms

of ABCP typically exist of credit enhancement and liquidity support (by the liquidity provider). Credit

support refers to the dependency of repayments supported by third parties. Distinction is made

between fully and partially supported ABCP programs.

Page 51: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

43 Master Thesis Vincent Bakker 21-03-2014

In fully-supported ABCP programs, credit losses in the transaction are full protected. Investors are

exposed to the risk of a third party that guarantees the repayment of the assets or receivables and not to

the risk of the performance of the assets or receivables themselves (Fabozzi & Choudhry , 2004).

Investors are not exposed to the credit risk of the asset portfolio. These programs are 100% credit

enhanced by a properly rated entity in order to guarantee the repayment of investors. In this case, the

analysis of the conduit is focused on the credit enhancement provider itself and not on the collateral

quality. The rating assigned to the ABCP is often corresponding to the rating of the enhancer.

Partially supported ABCP programs have less than 100% of credit enhancement available. In this case,

investors are partly exposed to the credit risk of the asset portfolio. They are, to some extent,

depending on the performance of the asset portfolio(s) of the conduit. This means that the analysis of

the partially supported ABCP will not only be focussed on the credit enhancement provider, but also

on the deal-specific credit enhancement and portfolio quality, including the asset quality and first loss

protection at deal-specific level. The rating of partially-supported ABCP programs depend on the

performance of the assets, the rating of providers of credit enhancement facilities, the rating of

providers of liquidity facilities and the conduit sponsor‟s expertise (Moody‟s, 2003).

In most cases, ABCP involve an asset-liability mismatch in which medium to long term assets are

financed with short term commercial paper. A risk of ABCP is the risk that investors may not be

willing to refinance maturing CP and no new investors can be found to roll over the CP (Kacperczyk

& Schnabl, 2010). This is called roll-over risk or liquidity risk. The roll-over risk increase risks for

investors because the conduit may go bankrupt if all investors stop funding the conduit at the same

time and the conduit is not able to sell of its assets to repay their investors (Kacperczyk & Schnabl,

2010). This also happened when the ABCP collapsed in 2007. Investors became concerned about the

quality of ABCP and their collateral. As a result, many investors were not willing to refinance

maturing CP, which increased the spread (above treasury rates) on overnight ABCP from 10 basis

points to 150 basis points within two days (Kacperczyk & Schnabl, 2010). The costs of funding via

ABCP became an expense form of funding within only two days.

The liquidity provider18

has an important role in ABCP securitizations. The liquidity provider

guarantees to take the CP that cannot be refinanced to investors. This liquidity guarantee ensures the

repayment of principal investment to investors. The transaction must have a liquidity support that is

able to cover the value of the CP to fund the transaction, in order to ensure the repayment to investors

and funding of the originator in the event of new CP cannot be issued or rolled over (Moody‟s, 2003).

In most cases, this is provided by the conduit sponsor that often operates as the liquidity provider of

the conduit. This bank provides liquidity to facilitate the ABCP transaction in case of timing mismatch

between cash flow proceeds and payments or in the case of CP cannot be rolled over by market

disruption (DBRS, 2013).

For multi-seller ABCP structures, liquidity support is generally provided at each transaction specific

deal and should cover at least 100% (GCRC, 2013). Liquidity support can be provided on by a

liquidity loan agreement (LLA) or a liquidity asset purchase agreement (LAPA) (GCRC, 2013). In

LLA, liquidity support is provided by a liquidity loan by which good (non-defaulting) assets of the

conduit are posted as collateral. In a LAPA, the good (non-defaulting) assets of the conduit are sold to

the liquidity provider (Moody‟s, 2003). Hence, the liquidity provider will bridge the timing

mismatches between repayment of maturing CP and either cash payments from proceeds of newly

18 Or providers

Page 52: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

44 Master Thesis Vincent Bakker 21-03-2014

issued CP (Moody‟s, 2003). Small volumes of CP that cannot be rolled over will be supported by the

liquidity provider. They will take over the position and wait for new investors to issue new CP and

reduce their support again.

In the case of larger volumes of CP cannot be rolled over to investors, stop-issuance and wind-down

triggers are used to minimize the losses resulting from the inability of rolling over the CP (Fitch,

2001). The activation of these triggers ensures that the ABCP deal-specific or program level is wind-

down or even stopped. The conduit will stop the issuance of new CP and liquidate its positions. These

triggers are defined at deal-specific and program-wide level (Fitch, 2001). In addition, the stop-

issuance and wind-down triggers are also used to minimize losses resulting from underperforming

asset portfolios (Fitch, 2001). This especially focuses on deal-specific performance. Deal-specific

triggers are used to wind-down or stop funding underperforming asset portfolios in order to ensure that

losses from an underperforming asset portfolio has limited effect to the entire conduit funding. The

dependence of unaffiliated originators in a multi-seller ABCP can be limited do to these stop-issuance

and wind-down triggers.

4.4 Assessment model for structure decision The alternative structures are to some extent suitable for the securitization of the car lease portfolio of

BFM and the main motivation of raising capital through securitization. In order to determine which

structure best suits, we examine their performance on a number of criteria that determine the

feasibility to BFM. The literature (Fabozzi & Choudhry, 2004; Fitch, 2001; Sabarwal, 2006; and

Tavakoli, 2008) is particularly focused on the flexibility of the structures. Less attention is paid to the

cost-effective deal size and certainty of the funding. However, these are the important criteria for the

finance company:

Flexibility

o Flexibility of the structure is the extent to which a structure can be organized to the

wishes and needs of the originator and the ability to reuse the structure for additional

funding.

Certainty

o Certainty of the structure is the extent to which the structure provides a secure and

long term debt solution to ensure continuity of the originator's business.

Cost-effective deal size

o The cost-effective deal size of the structure determines the minimum volume required

to cover all costs involved in the transaction. This includes all securitization costs,

funding costs and the costs of equity.

Figure 19: Structure assessment model

These criteria are used for the assessment of the most suitable structure for the finance company (see

Figure 19). The best suitable securitization structure is determined by high flexibility, high certainty

and a cost-effective deal size that is feasible for the finance company. The cost-effective deal size is

the key quantitative criteria for the feasibility analysis of a funding solution for BFM. The

Page 53: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

45 Master Thesis Vincent Bakker 21-03-2014

securitization process must be a cost-effective way of funding for the finance company, in order to

meet the return on equity and debt requirements. Lower cost-effective deal sizes enable the finance

company to start a securitization program at lower portfolio volumes.

Flexibility and certainty are qualitative criteria. Depending on the assets type, motivation,

requirements and boundaries of BFM, it is possible to assess the structures on these criteria on a

qualitative basis. Especially when there is little to no difference in the cost-effective deal size, these

criteria can be decisive for the choice of a securitization structure. The performance on the three

qualitative criteria is depending on the different features of the structures. The main features of the

structures are discussed in the previous sections. In Table 8 we summarized the main distinctive

characteristics and differences between the structures, based on a number of literature studies (BIS,

2009; Black Rock, 2011; DBRS, 2013; Fabozzi & Choudhry, 2004; Fitch, 2001; Kacperczyk &

Schnabl, 2010; and Moody‟s, 2003) and findings in earlier sections. In the next sections we will

explain how these features and differences lead to an assessment on the criteria.

Master trust Grantor trust Owner trust Multi-seller ABCP

Asset term Long & short Long Long Long & short

Security type Certificates Certificates Certificates Commercial paper

Maturity of

issued security

Over 1 year

(Capital market

debt)

Over 1 year

(Capital market

debt)

Over 1 year

(Capital market

debt)

1- 365 days (Money

market debt)

Maturity of the

program

Term, fixed life Term, fixed life Term, fixed life No final maturity,

perpetual

Repayment Interest &

principal or new

issuance

Interest &

principal

Interest &

principal

Interest & principal

or new issuance

Repayment

structure

Pass-through or

pay-through

Pass-through Pass-through Pass-through or

pay-through and

warehousing

Credit

enhancement

Deal-specific Limited deal-

specific

Deal-specific Deal-specific and

program-wide

(depending on

multi/)

New issuances New issuances

possible

Standalone Standalone New issuances

required (rolled

over)

Liquidity

support

Small Small Small 100% or partially

Table 8: Summary of the main features of ABS structures

4.4.1 Flexibility

A large part of the differences between securitization transaction structures is focused on flexibility.

The flexibility of a structure is dependent on a number of features that characterize the structure.

Characteristics such as cash flow structure of the transaction, diversification, credit enhancements and

new issuance possibilities determine the flexibility of the structure. More flexibility enables the

finance company to organise the securitization transaction to their needs and motivation.

Standalone & new issuance structures

Standalone securitization transactions are transactions that are established for one time securitization

and cannot be used for new issuance of securities. Each new securitization transaction requires the

originator to set up a new trust. New issuance structures allow originators to issue additional series

Page 54: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

46 Master Thesis Vincent Bakker 21-03-2014

from a single trust. The associated costs and effort with issuing new series is lower for new issuance

structures than standalone structures (Fabozzi & Choudhry, 2004).

Master trusts and ABCP structures do have the possibility to issue new series of securities through the

same structure and trust. In terms of new issuance possibilities, master trusts and ABCP are more

flexible than grantor trust and owner trust, which do not have the possibility to issue new series of

securities with the same trust.

BFM has a portfolio existing of assets with an average lifetime of 2-4 years. In that same period, a

new securitization transaction is necessary. The choice of a new issuance structure is preferred over

standalone structure, because this saves money and effort by issuing new securities instead of setting

up a new standalone structure for this relative short period.

Repayment structure

The repayment structure or cash flow structure is the way in which the cash proceeds from the

underlying portfolio is distributed to the investors. Grantor and owner trusts can only be structured

with a pass-through cash flow structure. Therefore, they have limited flexibility to modify the cash

flow structure. Master trust and ABCP can be either structured with a pass-through or a pay-through

structure, making them more flexible than grantor and owner trusts.

Another difference between the structures is the maturity of issued securities (Fabozzi & Choudhry,

2004; and Black Rock, 2011). ABCP issue securities with short maturities (30-365 days). Master,

grantor and owner trusts issue securities with longer maturities (over one year).

Pay-through structures enable originators to reinvest principal investments of investors and maintain

the asset portfolio with newly assets. The principal is used to buy new assets in the portfolio. This

enables master trusts and ABCP to securitize both long and short term assets into the transaction. This

provides more flexibility for ABCP and master trusts.

Diversification

In all structures it is possible to apply diversification in the portfolio existing of the same type of

assets. Multi-seller ABCP structures have the opportunity to finance multiple types of asset portfolios

through a conduit (Fabozzi & Choudhry, 2004; Fitch, 2001; and Black Rock, 2011). This ensures

additional diversification of portfolios, better risk spread and thus better credit ratings. The

diversification level for master, grantor and owner trust structures is only within a portfolio (or deal-

specific), where multi-seller ABCP structure has the possibility to diversify within and between

portfolios (or deal-specific and program-wide). However, you have no control over the other involved

portfolios in a multi-seller structure. So this flexibility of improving diversification is limited to the

conduit administrator.

Credit enhancement & Subordination

Deal-specific credit enhancement can be used in all structures. However, the levels of possible credit

enhancement methods differ amongst the structures. Grantor trusts are most limited in terms of credit

enhancement. Grantor trust can issue subordinate classes of securities, but only on an interest basis.

This means that losses of senior tranches are only covered by interest of subordinated classes. Owner

trusts have more flexibility to transfer cash flows amongst classes of securities. In owner trusts,

interest and principal of subordinated classes is used to absorb losses of senior tranches. Multi-seller

structures have the same flexibility of credit enhancement as owner trust. However, each additional

new issuance must meet the predetermined requirements for issuing senior and subordinated classes.

Confidential

Page 55: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

47 Master Thesis Vincent Bakker 21-03-2014

The credit enhancement of multi-seller ABCP can be established in deal-specific and program-wide

credit enhancement. Deal-specific credit enhancement is the portfolio specific credit enhancement.

This credit enhancement layer is the same as in master trusts. Program-wide credit enhancement is

used as a second layer to absorb credit losses of portfolios. This is the level of credit enhancement that

is applied to the whole structure (thus all portfolios) that is used to reduce program-wide credit risk.

However, you are dependent on the requirements of the conduit administrator in a multi-seller

structure. While this additional layer provides a double layer of credit enhancement, the flexibility is

limited to the requirements of the conduit administrator.

We have ranked the four alternative structures based on their flexibility in Table 9. Both master trust

and ABCP structures have many options to adapt the transaction to the needs and motivation of BFM.

Moreover, they can be used for multiple issuances of securities, making it possible to securitize

multiple parts of the portfolio at different time points through the same securitization program instead

of one large portfolio at a time. Although owner trust and grantor trust structures are deal-specific,

they have limited options to adapt the transaction to the needs and motivation of the finance company.

Master trust and ABCP structures are most suitable based on their flexibility.

Flexibility ranking

Master trust structure Very High flexibility

Multi-seller ABCP High flexibility

Owner trust structure Medium flexibility

Grantor trust structure Low flexibility Table 9: Flexibility ranking

4.4.2 Certainty

The financial solution must provide a secure source of funding which ensure the continuity of the

finance company. The aim is to obtain a secure funding solution for a long term. In particular, ABCP

differ from the other three structures in terms of certainty of the provided funding.

The ABCP structure is a short term debt instrument and raises capital at cheap short-term rates

(between 30-365 days) from money markets. Most ABCP conduits issues fixed rate CP, expressed on

a 365-day basis (Moody‟s, 2003). The interest on commercial paper is a little higher than interest rates

on Treasury Bills with the same maturity, and about to be the same as LIBOR rates (London Interbank

Offered Rate) and makes it one of the cheapest ways to obtain capital (Kacperczyk & Schnabl, 2010;

and Moody‟s, 2003). CPs are freely tradable in secondary markets among investors, but they are

usually held until final maturity. Rolling the CP (see Section 4.3) enables the originator to obtain a

source of long term funding. However, it is uncertain whether investors stay interested in buying these

CP in the future (DBRS, 2013; Kacperczyk & Schnabl, 2010; and Moody‟s, 2003). When investors

are no longer interested to invest in the CP and not willing to receive new CP, the issuer needs to find

financing elsewhere in order to repay maturing CP (new investors or liquidity provider). There is an

uncertainty that the CP cannot be rolled over to (new) investors. This puts the long term funding of an

ABCP structure at risk and may result in significant liquidity and solvency pressure if sponsors are

unable to refinance the portfolio (BIS, 2009)

The other three structures (master, grantor and owner trust) are long term (over one year) debt

instruments and raise capital from capital markets by the issuance of long term certificates. These are

therefore sometimes classified as „term‟ securitizations (Fitch, 2001; and Moody‟s, 2003). The interest

rate on certificates is often the LIBOR rate plus an interest spread or premium in accordance with the

risk of the asset portfolio. Despite the fact that the interest rate is higher than the rate of CP, it is a

more secure source of funding for the issuer due to the longer term of outstanding certificates.

Page 56: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

48 Master Thesis Vincent Bakker 21-03-2014

Furthermore, the interest rate on CP is less predictable than the interest rates on the longer term debt

(Fabozzi, & Choudhry, 2004). There is more volatility in short term rate than in long term rates,

making it more difficult to determine the interest rate on CP.

Master trusts have the possibility to issue new certificates. There must be investors willing to invest in

the new issuance. There is a little uncertainty that no investors will be found to invest in the additional

issuance. As a result, grantor and owner trust structures are slightly more secure source of funding. We

have ranked the four alternative structures based on their issuer certainty in Table 10. Both grantor

trust and owner trust are very attractive as a secure source of funding. For BFM, the long term debt

structures provide high to very high certainty.

Certainty ranking

Grantor trust structure Very high certainty

Owner trust structure Very high certainty

Master trust structure High certainty

Multi-seller ABCP Medium certainty Table 10: Certainty ranking

4.4.3 Cost-effective securitization

The portfolio of BFM can grow to a maximum of €100 million with the current maximum capital

capacity. The cost-effective deal size must be preferable at or below this level to make sure that the

return on equity of the finance company is guaranteed. In the literature, relatively little attention has

been paid to the transaction costs of a securitization. According to Fabozzi & Choudhry (2004), an

ABCP has a cost-effective deal size between 75 million and 150 million (or more). The cost-effective

deal size for the other ABS structures is between 150 and 200 million (or more). This also displayed in

Table 11. Multi-seller ABCP conduit can be used as a warehousing facility in order to accumulate the

asset portfolio (Fitch, 2001; Moody‟s, 2003). This enables the originator of the asset portfolio to

participate and benefit from the conduit funding, and provides the ability to let the portfolio grow in

prior of a „term‟ securitization (master, grantor or owner trust structure). When the portfolio volume

has grown to a certain amount (cost-effective deal size of „term‟ securitization), it can be decided to

convert the asset portfolio into a more secure long term securitization.

Cost-effective deal size Starting from:

Multi –seller ABCP € 75-150 million (or more)

Master trust structure € 150-200 million (or more)

Grantor trust structure € 150-200 million (or more)

Owner trust structure € 150-200 million (or more) Table 11: Cost-effective deal size of structures

On the basis of the numbers in Table 10, the multi-seller ABCP have the smallest cost-effective deal

size. Moreover, it is the only potential structure with a cost-effective deal size below the current

maximum capital capacity of BFM. Based on the cost-effective deal size of the different structures,

ABCP is the only possible securitization structure that can be cost-effective for BFM. The other

structures require a larger portfolio in order to obtain cost-effective funding.

However, these numbers are about 10 years old and can be a bit unreliable due to changing market

conditions and developing regulations. Moreover, these are general numbers and not primarily

intended for car related securitization. Despite the fact that we have checked these numbers by an

expert in the field of securitization (€50 million for ABCP and €250 million for “term” ABS), we have

examined whether this number is a reliable number for the case of BFM in the next section (Section

4.5).

Confidential

Page 57: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

49 Master Thesis Vincent Bakker 21-03-2014

4.5 Estimation of cost-effective deal size for BFM

The cost-effective deal size of a securitization transaction is depending on the net interest income and

additional securitization costs of the transaction. As the net interest income is high enough to off-set

the transaction costs of a securitization, it can be a cost-effective way of funding for BFM. The net

interest income is in turn depending on the interest revenue realized by the securitized portfolio and

the interest expense of the securitization transaction (interest rates offered to investors of different

tranches). The additional costs can be split into up-front costs and running costs. The dependency of a

cost-effective securitization is displayed in Figure 20.

Figure 20: Dependency structure of cost-effective securitization

The cost-effective deal size can be found with the following equation:

Net interest income- additional securitization costs = 0

However, it is practically not possible to calculate an exact number of the cost-effective deal size prior

to the potential securitization transaction of BFM, because it is not possible to quantify the variables

exactly in this early stage of securitization. Without assumptions it is practically not possible to

quantify the net interest income and additional securitization costs. Only empirical research can

provide support to determine cost-effective deal size of the structures in the current pre-securitization

phase of BFM (Wang, 2007).

Nevertheless, we have tried to determine the reliability of the cost-effective deal sizes (as given in

Section 4.4.3) of ABCP and ABS structures for the case of BFM with the aid of several assumptions

(for as far as possible). We have built an Excel model to estimate the cost-effective deal size for BFM.

In our model and calculations we have examined a very basic securitization transaction. Possible

defaults and credit enhancements or structural possibilities to improve the senior rate are disregarded

in our model, except the subordination of senior and equity tranches. As a starting point, we assume

that BFM retains a position in the equity tranche of 15% of the total volume. The other part (85%) is

defined as the senior tranche and is funded by an external party.

In this study we determine that the securitization is cost-effective, when the return on equity of BFM

remains equal or higher than the case without securitization (otherwise, it would result in a lower

return on investment for the group which has invested with equity in the finance company). With the

current revenue model, the return on equity is expected to be 11%.

4.5.1 Net interest income

The net interest income of the securitization transaction is the excess of the interest revenue of the

portfolio minus the interest expense of the securitization funding (Fabozzi & Choudhry, 2004; and

Gorton & Souleles, 2007). The interest revenue is depending on the weighted average return on assets

( and volume (V ) of the securitized portfolio. The interest expense is depending on the weighted

Confidential

Page 58: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

50 Master Thesis Vincent Bakker 21-03-2014

average cost of capital of the securitization transaction ( ) and the volume of the securitized

portfolio (V ). They can be calculated by:

=

=

The return on assets or is determined by the weighted average interest rate of the financial contracts

(Fabozzi & Choudhry, 2004). In case of BFM it is depending on an internal revenue model. The

revenue model of BFM is largely based on the weighted average cost of capital formula (WACC). The

standard formula of the WACC is given by: (

) (

), in which D is the

proportion of debt, E is the proportion of equity, is the expected return on debt and is the

expected return on equity (Brealey, Myers, & Allen, 2008). The basic WACC formula is used to

determine the minimum interest rate required to cover the costs of debt and equity. In addition, two

factors are added to the WACC formula. The first factor is the interest hedge component that is passed

on to customers. This is depending on the term of the lease contract. The second factor is the cost

spread that must cover the costs of the finance company. The cost spread factor is depending on the

type of customer (see Chapter 3). On top of that, the customers have the opportunity to fund a small

part of the contract by themselves, through the deposit of subordinated debt with a rate equal to the

(WACC + cost of interest hedge + cost spread) and a term equal to the contract term. The revenue

model is modelled in such a way that it always provides a return on equity of 11% regardless of the

other input parameters in the model. This is the required return on equity for the finance company and

defines the cost-effective deal size for BFM. For a more detailed explanation of the current revenue

model, we refer to Appendix 7.

In our model we have made the assumption to fix of the portfolio based on the expected growth

(see Section 3.3) and revenue model. By adjusting the parameters of the revenue model, it is possible

to influence the contract rate of future contracts. However, it is not possible to change contractual

interest rates of already closed contracts. In the case of securitization, a portfolio of existing assets is

securitized. This means that the interest rate of contracts is determined on forehand. Despite the fact

that it is possible to influence the contract rate of future contracts, we classify of the portfolio as a

“fixed” parameter in our model, because this is already determined at commencement of the contracts.

The cost of capital of the securitization transaction or is determined by the coupon rates

offered to the holders or investors of issued securities on different tranches and the volume of these

tranches. It is determined by the weighted average interest rate paid to investors that have a position in

securities (Fabozzi & Choudhry, 2004). The exact height of the rates is depending on the quality and

structural characteristic (especially subordination) of the securitization transaction. For simplicity we

assume that the transaction involved 2 tranches, an equity tranche and a senior tranche. The formula

for the is therefore comparable to the basic WACC formula: (

)

(

), in which S is the proportion of senior tranche, E is the proportion of equity tranche and

and the corresponding interest rates of the tranches. As already mentioned, the proportions of equity

tranche and senior tranche are fixed (15% and 85% of the total volume). We assume that the equity

tranche is retained by BFM. Thereby, S and E are determined in our model.

is the unknown parameter we are looking for in our model.

The senior coupon rate on commercial paper is, on average, higher than interest rates on Treasury

Bills with the same maturity, but a bit lower than LIBOR rates with the same maturity (Kacperczyk &

Confidential

Page 59: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

51 Master Thesis Vincent Bakker 21-03-2014

Schnabl, 2010)19

. The coupon rate on certificates of term ABS structures is often the LIBOR rate plus

an interest spread or premium in accordance with the risk of the asset portfolio20

. The exact height of

the coupon rate is depending on the risks and structural factors that influence the quality of the

securitization transaction and the actual market for commercial paper and securitization securities. In

this pre-securitization phase it is hard to define an exact expense rate for the case of BFM. Therefore,

we vary the coupon rates on commercial paper and securities in our model in order to determine the

cost-effectiveness at different coupon rates based on the average spread rates on ABS and ABCP.

Thereby, we defined .

Besides varying the coupon rate to senior tranche investors, we also vary the portfolio volume in the

model. The portfolio volume (V) is a key variable that determines the amount of income and expense,

and thus the cost-effective deal size. The height of the total volume ultimately determines whether the

additional costs of securitization can be offset by the lower interest expense. The total volume and its

allocation to tranches are decisive whether or not to perform a securitization of assets.

4.5.2 Additional securitization costs

The additional securitization costs are the costs involved in setting-up, implementing and maintaining

a securitization. There is little to no attention in the literature or on the internet for additional costs of a

securitization, due to the fact that securitizations are differently structured and thus have different cost

structures. It is therefore difficult to determine the additional costs of a specific securitization.

Nevertheless, to analyse and estimate the additional costs in a reasonable way, we have divided the

costs of securitization in 2 categories: up-front cost and running cost. This enables us to make the

costs more transparent. We have asked several experts in the field of securitization to provide

information about the additional costs of a securitization transaction in accordance with our potential

asset portfolio and the current market conditions (see Appendix 8). This has enabled us to identify and

estimate the additional costs of a securitization transaction for both fixed up-front and running costs.

Up-front costs are the costs that arise in the preparation and set-up phase of the securitization process.

For example, structuring the legal aspects of the securitization, the establishment of an SPV and

getting a credit rating from rating agencies involve serious costs before even starting the securitization.

We assume that the (estimated) up-front costs of the securitization transaction can be classified as

fixed costs. As an originator of a securitization transaction, you have very limited influence on these

costs. A number of fees and costs of transaction participants can be hardly influenced. The only

probable (small) variation is the fee price demanded by third parties. Therefore, we classify up-front

costs as “fixed” costs. The costs below are based on discussions and documents provided by experts in

the field of securitization. Total amount of up-front costs are displayed in Figure 21. These total costs

must be annualized according to the expected term of the securitization structure.

19 The coupon rate on asset-backed commercial paper is expected to be between 0,1% and 0,3%

(source: http://www.federalreserve.gov/releases/cp/rates.htm).

20

Two recent Dutch car related lease securitization transactions have a senior rate of 1,3% (Bumper 4 Finance

B.V. – Leaseplan ) and 1,23% (Highway B.V. - Athlon). Source:

http://www.leaseplan.com/images/en_LP/bumper_4_sp_issue_report.pdf

Page 60: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

52 Master Thesis Vincent Bakker 21-03-2014

Figure 21: Estimation of fixed up-front costs (left) and running costs (right)

Running costs are the costs that arise during the execution of the securitization. For example, servicing

the SPV and payment control involves serious costs to the running process of securitization. Running

costs consist basically of two types of costs. The first category can be compared to the up-front cost in

terms of periodic fees to transaction participants that stay involved in the transaction for a fixed

amount per period. As in the case of up-front costs, we assume that these costs can be classified as

“fixed” costs. The first part exists of fees and an estimation (based on experts opinion) of these fees is

displayed in Figure 21.

The second category of running costs is depending on the volume of the portfolio. The price of some

specific roles or running costs in the securitization process is based on a percentage of the portfolio

volume. We assume that these cost percentages are also fixed based on the same reason as up-front

costs. As an originator of a securitization, you have very limited influence on these running cost

percentages. We classify this part of the running costs also as “fixed” costs.

For the term ABS, these are the underwriting costs and interest hedge costs. The IRS hedge costs can

be estimated by the IRS rate corresponding to the term of the contracts. The underwriting is a

premium for the sponsor for marketing, attracting and finding investors. Based on expert opinions, the

fees of underwriting are equal to 0,25% of the portfolio volume.

For ABCP, these fees exist of: liquidity premium, credit enhancement premium, underwriting

premium and interest hedge cost, but banks turned out to be very reluctant in providing information

about their conduit fees. The credit premium and liquidity premium are depending on the ultimately

transaction quality and structure. The IRS hedge costs can be estimated by the IRS rate corresponding

to the term of the contracts. Often these are paid at one rate to the conduit sponsor who arranges all

supports and lies between 0,5% and 3%, depending on the quality of the portfolio and the originator.

However, this range is too large in order to make useful calculations. For medium-sized lease

companies, this amount is around 2,25% (by expert opinion). Depending on the quality of the portfolio

and originator, this premium can be lowered. In the case of BFM has the advantage of a two layered

credit protection by customers and end customers. We expect a lower rate based on the double credit

protection. We assumed the following rates in our model.

The conduit sponsor will account a 0,25% fee for underwriting the commercial paper (same as

in term ABS).

We assume that the liquidity sponsor premium fee is 0,3%

We assume that the CE provider fee is also 0,3%.

Up-front costs Estimated cost

Revieuw Counsel 100.000€

Legal advise fees ( incl reporting) 375.000€

Accounting and tax advice 25.000€

Listing fees 2.500€

SPV and trust establishment 10.000€

Rating agent 337.500€

portfolio audits 2.000€

Cash manager 5.000€

account bank 3.000€

paying agent 2.000€

trustee 5.000€

Data model 50.000€

Total 917.000€

Running costs/ fees (per month)

SPV Administrator 10,000€

SPV trustee 10,000€

Cash manager 5,000€

Account bank 3,000€

Aaying agent 2,000€

Rating agent 10,000€

Total fees 40,000€

Per year 480,000€

Page 61: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

53 Master Thesis Vincent Bakker 21-03-2014

4.5.3 Model

Recall the equation of the cost-effective deal size:

Net interest income- additional securitization costs = 0

Above, we defined the net interest income and additional securitization costs. This enables us to

determine an equation to determine the cost-effective deal size for BFM:

– (annualized up-front costs) – (running costs) = 0.

– (

) ((

) )] – (annualized up-front costs) – (running costs*(1+V)) = 0

is the unknown parameter which is computed by the model. Recall that we assume that BFM

retains the equity tranche position. In our model, we will vary the volume and rate on senior tranches.

The securitization structure is cost-effective for BFM when the output of is equal or higher than

11%. In reality, the equity tranche rate will have an interest rate of around 5%. On top of that, the

originator (BFM) receives the excess spread generated by the securitization transaction. Extra return

on the securitization transaction will be classified as excess spread (see Section 2.6.2). This excess

spread will ultimately be provided to the originator (BFM) as a profit and can be accounted to the

return on equity factor .

4.5.4 Results

Our calculations indicate that the range of ABCP lies between € 92 million and € 115 million and the

range of ABS between € 163 million and € 629 million (se Appendix 9 for the detailed calculations).

The range for ABCP seems to correspond to the range of Fabozzi, & Choudhry (2004). Our estimated

range of ABS is much wider than the range of Fabozzi, & Choudhry (2004). According to our model,

it is more cost-effective to participate in a multi-seller ABCP than using one of the other securitization

structures. The difference is mainly attributable to the lower interest rate on commercial paper.

Nevertheless, it is a less secure form of securitization funding for the long term compared to the other

structures.

We have also tried to incorporate the effect of the percentage of subordinated debt posted by

customers. It turned out that the cost-effective deal-size will not change when the percentage of

subordinated debt increases. Nevertheless, the results show differences in the steepness of the return

on equity. As the percentage of subordinated debt increases, the return on equity becomes more

sensitive to the portfolio volume. For more details on the model and results we refer to Appendix 9.

However, it turned out to be hard to determine a cost-effective deal size, since we do not have

visibility in all costs and variables. We have estimated the costs based on the experiences of experts in

the area of securitization. Some costs can only be identified at a later phase of the (pre)securitization

process. Moreover, banks (often the sponsor) are reluctant to provide information about the fees they

charge for several supports in securitisation transactions. They may provide more clarity by entering

into a confidentially agreement in which the bank will act as the sponsor of the potential securitization

transaction.

4.6 Conclusion The objective of this chapter was to identify the most suitable securitization structure for the asset

portfolio and motivation/needs of BFM/C4L. Four common true sale securitization structures are

examined in this chapter:

Confidential

Confidential

Page 62: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

54 Master Thesis Vincent Bakker 21-03-2014

Master trust structure

Grantor trust structure

Owner trust structure

(Multi-seller) ABCP conduit structure

In order to determine which structure is most suitable for BFM, we have established an assessment

model based on three criteria:

Flexibility; the extent to which a structure can be organized to the wishes and needs of the

originator and the ability to reuse the structure for additional funding.

Certainty; the extent to which the structure provides a secure and long term debt solution to

ensure continuity of the originator's business.

Cost-effective deal size; determines the minimum volume required to cover all costs involved

in the transaction. This includes all securitization costs, funding costs and the costs of equity.

The key criterion for BFM is the cost-effective deal size. Multi-seller ABCP turned out to have the

lowest cost-effective deal size and have the only potential cost-effective deal size below 100 million.

Participating in a multi-seller ABCP conduit has the advantage of having a much lower cost-effective

deal size compared to the other structures, and even fall within the maximum capital capacity of BFM.

Multi-seller ABCP structure scored also well on flexibility, because the conduit funding can be used

on an on-going basis (warehousing), allowing the portfolio to grow towards a larger portfolio volume

within the same securitization structure. By warehousing the asset portfolio in a multi-seller conduit it

is possible to let the portfolio grow to a higher volume. The first step to securitize the financial assets

of BFM and raise capital is to participate in the conduit financing of a multi-seller ABCP conduit of a

large financial institution. This enables the finance company to let the portfolio grow above the current

maximum capital of 100 million in a cost-effective way.

However, ABCP score less well on the certainty of the funding. When BFM chooses to participate in a

multi-seller ABCP, the medium term asset portfolio of BFM will be funded by short term paper. New

CP must be rolled over multiple times in order to fund the asset portfolio. This asset-liability mismatch

can have negative influence when ABCP cannot be rolled over and results in a less well secure long

term funding.

As the volume of the portfolio increases (via participating in a multi-seller ABCP structure) it can also

become cost-effective to use one of the other structures within the foreseeable future. These structures

have a cost-effective deal size of about €200 million. From this volume, it can be interesting to use a

„term‟ securitization. These structures provide a more secure long term funding. Based on our findings

in this chapter, the master trust structure is the most suitable structure for the finance company,

because it offers the highest flexibility and high certainty for long-term fund. It provides the

opportunity of issuing new securities through the same structure. This is particular interesting for the

portfolio of BFM, which exist of assets with a maturity of about 2-4 years. Multiple parts of the

portfolio can be securitized on different time points through the same structure. Using a master trust

securitization structure may be the second step on the long term in the funding strategy of BFM.

Although we are quite sure of the first step and potential second step, this conclusion can be a bit

questionable. It is doubtful whether the numbers mentioned by Fabozzi & Choudhry (2004) are still

reliable cost-effective deal sizes. Changed market conditions and new regulation for financial

institutions may have influenced these numbers, making them less reliable. Our own cost-effective

deal size model confirmed that the cost-effective deal size range of ABCP is quite reliable, but the

Confidential

Page 63: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

55 Master Thesis Vincent Bakker 21-03-2014

range of the other ABS structures is much wider. However, we had to make a number of assumptions

in our model, whereby the reliability of the model can be a bit questionable.

Within this chapter we have answered research question 3: Which ABS structure is most suitable to

BFM for the organization of the securitization of the asset portfolio of the finance company? However,

some further investigation is needed to determine the level of cost-effective deal sizes per structure.

These will be identified and quantified in the next chapters.

Page 64: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

56 Master Thesis Vincent Bakker 21-03-2014

Chapter 5: Key rating drivers The objective of this chapter is to determine the key rating drivers or risks that have an influence on

the cost-effectiveness of the securitization of the asset portfolio of BFM/C4L and create a framework

to get control on these key rating drivers. This framework can provide comprehensive support for the

organization of the potential securitization transaction. A company should be well prepared in order to

use securitization as a funding strategy. It is important to determine the requirements and assumptions

that make a securitization funding strategy more readily applicable. In particular, small to medium

sized companies need a proper infrastructure in order to utilize a beneficial securitization funding

strategy. The cost-effectiveness of the obtained capital is depending on the risks involved in the

securitization transaction. In car related ABS transactions, rating agencies (Fitch, 2011; Moody‟s,

2011; and S&P, 2011) are focussed on two key rating drivers:

credit risk

residual value risk

In this research, we are particularly focused on these two key rating drivers (credit risk and residual

value risk). They have the most influence on the credit rating and pricing of the securitization

transaction. In addition to credit risk and residual value risk, rating agencies have identified a number

of other rating drivers that may influence the quality and credit rating of car related ABS transactions.

This chapter enables us to answer research question (3): What are the key rating drivers that influence

the cost-effectiveness of the car financing securitization program and how do you control them?

In the first sections of this chapter we will define credit risk and residual value risk. We will also

discuss to what extent the risk affect the case of BFM. Then, we explain the quantification process in

order to determine how the two key risks affect the rating and pricing of the securitization.

Furthermore, we will explain how these risks can be made insightful and controllable for BFM. Next,

we identify and define the other risks that may have an influence on the pricing and rating of the

securitization transaction. We will end up with the framework of key rating drivers that can be used to

get control on the rating drivers and be used as a guideline for the organisation of the securitization

transaction of the car financing portfolio.

5.1 Credit risk Credit risk is a primary concern and is a key rating driver in rating securitization transactions. Credit

risk is the risk that the obligor will default on its obligation to make periodically payments under an

agreed contract, resulting in a loss (Doff, 2005; and S&P, 2011). A default in a car lease contract is

realized when the lessor has unilaterally cancelled the agreement, because the obligor did not met his

obligation to make periodically payment under an agreed contract (Schmit, 2004). In the event of a

default, the lessor is able to repossess the car and claim any losses incurred by the default (Schmit,

2004). A credit loss occurs when the proceeds from the sale of the repossessed car, insurance claim

and judgements collected from the obligor are insufficient to cover the remaining securitization value

(Fitch, 2011).

The major part of the recovery on the defaulted contract will be reimbursed by the sale of the car.

Moreover, there is usually no money left to pay the claims, whereby the recovery is often solely based

on the market value of the car. The market value of the car should therefore cover the carrying amount

of the contract in order to eliminate the credit risk. However, this is often not the case. A mismatch

between the book value of the contract and the market value of the car during the contract can possibly

result in a loss (or profit) in the event of a default. This is displayed in Figure 22.

Page 65: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

57 Master Thesis Vincent Bakker 21-03-2014

The figure is an example of a 3-year lease contract with an initial value of €20.000 and a final payment

of €10.000 (based on an expected residual value of €10.000 at lease end). The red line is the

outstanding amount or book value of the contract at a specific month, which exists of two parts: an

amortization part and a residual value part. The amortization part represents the depreciation of the

car, which is repaid at a constant rate (annuity). The residual value part is the expected residual value

of the car at lease end. The green line represents the expected market value of the car during the

contract term. As the prediction of the car‟s value is correct and periodically payments are paid

„normally‟, the car is worth €10.000 at lease end which is equal to the final payment.

Figure 22: Example of exposure to potential credit loss of a car lease contract

In the event of a default during the contract term, the market value of the car is less valuable than the

book value of the contract, because the car depreciates faster than the repayment on the contract at the

beginning of the term (see DBRS, 2010). This means that during the contract, the finance company is

exposed to credit losses in the event of default (indicated by the area between the red and green line).

5.2.1 Credit risk in portfolio of BFM

The portfolio of BFM is exposed to credit risk on a one or two-layered base (as displayed in Figure

12), depending on the customer type. In the case of management & funding and funding customers, a

default can happen on two layers. The first default possibility is a default of the end customer. In that

case the lessee of the leasing company is unable to make its periodic payments under the agreed lease

contract. The car is transferred back to the leasing company and a claim is filed against the end

customer. This claim contains a penalty for early termination of the contract, a payment on possible

damage, a settlement of any excess mileage driven and a claim of the outstanding amount. However,

in most cases the end customer is bankrupt and, besides the repossession of the car, only a small

portion is recovered. The ultimate responsibility of the contract and underlying car is at the leasing

company. Any losses on the defaulted contract with the end customer are therefore for his account.

The financial lease contract with C4L remains valid. The leasing company may decide to turn the car

into a new lease contract, or early terminate the financial lease contract with C4L (against a final

settlement for early termination). This means that a default of end customers does not affect the

finance company.

The second default possibility is the default of a leasing company. In that case, the leasing company is

unable to make its periodically payments agreed in the financial lease contract with C4L. The

(defaulted) lease contracts of the leasing company with the end customer will then be carried over to

the leasing company of C4L (label lease portfolio), who will perform as the lessor of the contract with

Confidential

Page 66: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

58 Master Thesis Vincent Bakker 21-03-2014

the end customer for the remaining contract period. In this way, the lease contract of the end customer

simply continues. The early termination will lead to a claim against the leasing company to cover

missed payments. This means not only that C4L becomes the economic owner of the car, but also ends

up with the car at the end of the lease term, because the redemption statement with the leasing

company is no longer valid. At that point, C4L is exposed to credit risk as well as residual value risk

of the car.

In the case of management & funding and funding customers, both the leasing company and end

customer must default to cause a credit loss at BFM. Therefore, this two-layered structure provides an

extra credit risk buffer for BFM before a credit loss will affect the finance company.

In the case of label lease contracts, there is only one layer of default possibility, namely a direct

default of the end customer. In that case, BFM is directly exposed to a credit loss in case of a default

of an end customer.

5.2 Residual value risk The residual value risk is a key risk in car related securitization transactions. Residual value of car

leases is the sale price of the vehicle at the end of the contract term. Residual value risk in car leases is

the risk that the value of the leased car at the end of the lease contract is lower than the predetermined

expected residual value at start date (Fitch, 2011).

A residual value loss arises due to a lower fair value of the asset than its residual estimated value at

lease inception (Pirotte, Schmit, & Veassen, 2004). Depending on the difference between the

predetermined residual value and the actual residual value at lease end, there may be a loss if the

actual residual value of the vehicle is lower than the estimated residual value. A faster than expected

depreciation of car (depending on market development), will result in a residual value loss. This is

displayed in Figure 23, which is based on the same numbers in the example of Section 5.1. In addition,

a blue line is added, which is the actual residual value development (in this example). The actual

residual value of the car is depreciated at a faster rate, which in the end results in a difference between

the expected market value of the car and the actual residual value of the car at lease end. This is the

residual value loss (It is also possible that the car depreciates slower than expected, which lead to a

gain). If the returned car is sold for less than the base value or contract stated residual value, a residual

value loss is occurred (DBRS, 2012). Depending on the expected turn-in rates of cars and the expected

market value development for used vehicles, the exposure to residual risk can be determined.

Figure 23: Example of exposure to potential residual value loss of a car lease contract

Confidential

Page 67: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

59 Master Thesis Vincent Bakker 21-03-2014

Residual value risk is present in all type of lease contracts. Depending on the type of contract, the

potential loss on residual value may be for the account of the lessee or lessor (Fitch, 2006). In

operational lease contracts, the economic and legal ownership of the underlying assets is with the

lessor (originator) of the contract. At the end of the lease term, the car is (in most cases) returned to the

lessor. The lessor is responsible for the sale of the car and is directly exposed to the residual value of

the car. Any losses on residual value are for the account of the lessor.

The residual value of the underlying asset is typically included in the securitization transaction. This

means that the risk of losses on residual value is passed through to the issuer and, in turn, to investors.

Thereby, the compliance of (operational) auto lease securitizations is not only affected by credit risk,

but also strongly depends on the performance of residual value and is directly exposed to (historically)

volatile used vehicle market (Fitch, 2011; and Moody‟s, 2011a).

The situation for financial lease contracts is different. In financial lease contracts, the economic

ownership of the underlying assets is with the lessee of the contract. In financial lease contracts, the

lessee can agree two options:

Compulsory purchase: He agrees to buy the car at lease end against a predetermined final

instalment

Option to buy: He agrees an option to buy the car at lease end.

In the first case, the customer is required to buy the car for a predetermined amount. If the market

value of the car at lease end is lower than the predetermined final value, a loss is incurred. This loss is

passed on to the lessee, because he is obligatory to buy the car (Fitch, 2006). Only in the event that the

customer is unable to pay the final sum, the loss will be for the account of the lessor. In that case, he

defaults on the final payment.

In the second case, the customer can choose whether he buys the car at lease end. If we assume a

rational customer, he would buy the car when the value is higher or equal than the market value. The

customer will return the car if the market value is lower that the predetermined option price. In his

case, the losses are for the lessor.

Typically, a claim on the final instalment of a financial lease contract is securitised in the transaction.

For the compulsory purchase structure, the issuer bears the risk of residual value losses in case of a

default of the customer on the final payment. For the option to buy structure, the issuer bears the risk

of residual value losses when customers do not use their option to buy the car and return the car at the

end of the lease term.

5.2.1 Residual value risk in portfolio of BFM

Residual value risk of a portfolio is determined by the turn-in rate and residual value realization rate

(Fitch, 20011; and Moody, 2011). Turn-in rate is the percentages of non-defaulted obligors that return

their car to the lessor (loss frequency). Residual value realization rate is the difference between the

expected predetermined residual value and actual residual value at lease end (loss severity).

The portfolio of BFM exists of operational lease contracts and (for the most part of) financial lease

contracts with a redemption statement on top of it, by which potential loss on residual value is

transferred to the lessee or vendor (BOVAG enterprise). The contracts are established with a

compulsory purchase agreement. In order to realize a turn-in rate, non-defaulted obligors have to

return their car. However, this is not possible in the case of BFM, since obligors are required to

purchase the car according to the redemption statement. This means that BFM is not directly exposed

Confidential

Page 68: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

60 Master Thesis Vincent Bakker 21-03-2014

to residual value risk. If a lessee or BOVAG enterprise is unable to make the final instalment agreed in

the redemption statement, the obligor defaults on the final payment. A defaulted obligor that return the

car is not classified as a turn in rate according to the definition of rating agencies, but a credit loss on

final payment. In the case of a default on the final payment, the finance company should sell the car in

the market against the market value just as in the case with a default during the contract term. A claim

on the final instalment of a financial lease contract can be securitised in the transaction to fund the

residual value of the underling car in the contract.

5.3 Control of rating drivers

The establishment of a credit rating and pricing is determined by the rating drivers of a securitization

transaction. To gain more insight into the credit risk modelling of rating agencies, we have

investigated the credit rating approaches and requirements for auto lease securitizations of the three

rating agencies (Fitch, 2011; Moody‟s, 2011; and S&P, 2011) and the Portfolio Credit Model of Fitch

(Fitch, 2013). This model uses Monte Carlo simulation to derive a distribution of portfolio default and

loss rates (Fitch, 2013). This method is similar to the Value at Risk method (VaR). VaR is a method to

determine a single number that summarizes the total credit risk of a portfolio. The single number

represents the maximum amount to lose within a confidence level and time period.

Credit risk and residual value risk are the two key rating drivers in a car lease securitization. The

quantification of credit risk and residual value risk in car lease securitization is depending on a number

of variables (Fitch, 2013). Rating agencies determine the credit risk of a portfolio by a number of

quantifying variables (ECB, 2007; Fitch, 2006; Fitch, 2013; Hull, 2010; and Schmit, 2004):

Probability of a default (PD): a measure of the probability that an obligor defaults over a

specified time horizon.

o Maturity: the average time to maturity of outstanding financial contract in the

portfolio.

Recovery rate: the (discounted) percentage of the principal that can be retrieved by selling of

the collateral and proceeds from claims against the obligor in case of a default. This is 1- loss

given default.

o Loss given a default (LGD): the expected amount of loss in the event of a default.

This is calculated from the recovery rate and the exposure at default (EAD).

o Exposure at default (EAD): the value of the contract at the moment of default.

Default correlation: a measures for the extent to which assets default together. In credit risk

literature, this is often called default correlation.

The rating agency uses Monte Carlo simulations to derive a base distribution of portfolio default and

loss rates based on the portfolio data. Subsequently, for each credit rating level a rating default rate

(RDR) and a rating loss rate (RLR) is determined in a similar way as the VaR method. The RDRs and

RLRs are the percentiles on the default and loss distributions that correspond to the specific

confidence levels of each credit rating (Fitch, 2013).

Default correlation in an asset portfolio is the most difficult parameter to determine (ECB, 2007). It

measures the extent to which two obligors will default in the same period (Zhang, Zhu, & Lee, 2008).

Distinction is made between positive default correlation and negative default correlation. Positive

default correlation (for example when both obligors operating in the same industry or company) and

negative default correlation (for example when a default or elimination of one obligor, increases the

market share of the other obligor) (ECB, 2007). However, this correlation is very hard to estimate,

because defaults (and in particular correlated defaults) occur rarely and data on default is often very

Confidential

Page 69: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

61 Master Thesis Vincent Bakker 21-03-2014

limited available (ECB, 2007). Therefore, rating agencies are focussed on asset correlation to estimate

the default correlation within a portfolio (ECB, 2007). Asset correlation is the extent to which asset

values move together within a portfolio (Fitch, 2006). In combination with default probabilities, they

are able to model default correlation.

However, the variables have to be quantified prior to the simulation. The quantifying variables of

credit risk and residual value risk are depending on a number of influencing factors and the historical

performance of the portfolio (Fitch, 2011; and Fitch 2013). Historical portfolio performance is

particularly focussed on the payment behaviour of obligors in the portfolio of assets. The influencing

factors are current characteristics of the asset portfolio and market conditions that are used to

determine the asset correlation and influence on the value of variables. The quality of both historical

performance and influencing factors is determined by a number of indicators. The quantification

structure is displayed in Figure 24.

Figure 24: Quantification structure for the assessment of credit rating and pricing of a car lease securitization

transaction

5.4 Historical portfolio performance data

Historical portfolio performance is a key input to determine expected future pool performances under

various scenarios, in particular payment behaviour of obligors. Rating agencies expect to receive

historical data to obtain a credit rating (Fitch, 2006). They try to estimate a full probability distribution

of the expected credit loss of the pool and its variance, based on the estimates of the expected credit

loss and its variance (Fitch, 2011; and Moody‟s 2011a). The rating agencies expect to receive at least

3 to 5 years of historical performance data of the portfolio of defaults and delinquencies (Fitch, 2011;

and Moody‟s 2011a). It is important to keep detailed metrics as preparation to achieve a high credit

rating securitization transaction (Fitch, 2011). The (historical) payment performance of car lease

securitization transactions can be measured by delinquencies and defaults. In order to measure this

accurately it is important to define whether an asset is delinquent or in default.

A delinquency in a loan or lease occurs when a borrower fails to make one or more periodically

payments under an agreement (Fabozzi, Davis, & Choudhry, 2006). Portfolio delinquencies provide

insight in the payment performance of lessees and refer to the number of days that a lessee failed to

make his payment. By defining delinquencies correctly, it is possible to gauge whether lessees are

unable to make its payments and the seriousness of the delinquencies. More insight in the lessees with

delinquencies and their seriousness is obtained by defining classifications of delinquencies (Fabozzi,

Page 70: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

62 Master Thesis Vincent Bakker 21-03-2014

Davis, & Choudhry, 2006). We use the most common method of delinquency classification, which

was recommended is the Office of Thrift Supervision (OTS) and broadly used in ABS transactions21

:

Current delinquent: Payments to 30 days late

30 days delinquent: Payments from 30 to 60 days to late

60 days delinquent: Payments from 60 to 90 days to late

90+ days delinquent: Payments 90 days or more to late

If the lessee is unable to meet its payments, it is possible that he goes into default. A default in a car

lease contract is realized when the lessor has unilaterally cancelled the agreement, because the obligor

did not met his obligation to make periodically payment under an agreed contract (Schmit, 2004).

Generally, defaults occur for leases that are 90+ days delinquent with no prospect of improvement of

periodic payments.

The basis for credit loss analysis is the portfolio loss data and the static pool loss data. Portfolio loss

data is simply the losses that occur in each period as a percentage of that period outstanding portfolio

balance, which composition is changed over time (Moody‟s, 2011a). The conditional default rate

(CDR) provides insight in the development of defaults per month on an annualized basis. A static pool

loss data is an isolated static subsets of originated contracts and used for a detailed tracking of its

performance of the contracts over time (Fitch, 2011). It is used to determine the expected credit

defaults and net losses that arise in the securitization. It shows the ratio of cumulative losses to original

lease balance for a static pool of assets. The cumulative default rate (CDX) is the proportion of leases

in the portfolio that has gone into default as percentage of the total value of the portfolio. The loss

curves derived from the static pool data are used to estimate expected losses based on the static pool.

These expected losses can be applied to the securitized portfolio, in order to determine the total

expected loss from defaults of the securitization transaction (Moody‟s, 2011a).

Fabozzi, Davis, & Choudhry (2006) discuss a combination of two parameters for quantifying default

performance in an asset portfolio. The conditional default rate (CDR) is the annualized value of the

balance of new defaulted leases. This is calculated over the course of a month, as a percentage of the

unpaid balance of the portfolio at the beginning of the month. The conditional default rate for month t

is calculated as follows:

In order to get the annualized CDR, the following formula is used:

.

The CDR provides insight in the development of defaults per month on an annualized basis. In the

same way, conditional delinquency rates can be determined. (Moreover, this can be split into the

different delinquency classes as explained in above).

The cumulative default rate (CDX) is the proportion of leases in the portfolio that has gone into

default as percentage of the total value of the portfolio. This is calculated as follows:

21 OTC was a department of treasury that was involved in supervision and regulation of federal chartered and

state chartered banks, savings and loan associations.

Page 71: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

63 Master Thesis Vincent Bakker 21-03-2014

In the same way, cumulative delinquency rates can be determined. (Moreover, this can be split into the

different delinquency classes as explained in above). Default and delinquency rates alone do not

provide sufficient insight into the performance of a portfolio. It could happen that a number of defaults

in a portfolio results in small losses, while one default in a portfolio can result in large loss. Therefore,

rating agencies also focus on the impact of a default (Fitch, 2011; Moody‟s, 2011a; and S&P, 2011).

In the event of a default, the lessor is able to recover a portion of the value of the lease contract as

explained in Section 4.2. The proceeds from the legal recovery process and sale of the car can be used

to reduce losses on defaults. Fabozzi, Davis, & Choudhry (2006) define a parameter for the loss

severity rate or LGD rate in order to measure recovery effects. However, rating agencies prefer to see

recovery rate in order to measure recovery performance of portfolios. Therefore, it makes sense to

define a recovery rate based on the LGD rate22

. The LGD for month t is calculated as follows:

and Recovery rate = 1-LGD

Both portfolio loss data and static pool loss data should be tracked on two layers to gain insight into

the entire cash flow chain. The contracts of label lease and management & funding customers, are

entirely managed by C4L/BFM. Thereby, C4L/BFM has insight in the payment behaviour of both the

customer and end customer. A database should be created to store the conditional default and

delinquency rates. For funding customers it can be more complex. Funding customers operate on their

own, whereby C4L/BFM has limited insight in the payment behaviour of end customers. To complete

the database of historical portfolio performance, a data model must be built to get the relevant data to

BFM.

For the performance of realization of residual value it is important to determine the loss frequency and

severity. Residual value risk of a portfolio is determined by the following key variables (Fitch, 20011;

and Moody, 2011):

Turn-in rate: the percentages of non-defaulted obligors that return their car to the lessor (loss

frequency).

Residual value realization rate: the difference between the expected predetermined residual

value and actual residual value at lease end (loss severity).

5.5 Influencing factors & indicators Historical portfolio performance data is not the only necessary input data to get a securitization

transaction rated. Four influencing factors that are determinative for the future portfolio performance

and its credit risk are (Fitch, 2011; and Moody‟s, 2011):

Obligor profile

Collateral quality

State of car industry and market

Macroeconomic conditions

22 Recovery rate = 1 – loss severity rate

Confidential

Page 72: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

64 Master Thesis Vincent Bakker 21-03-2014

The factors can be determined by a number of indicators. In particular, the data of obligor profiles and

collateral indicators are of interest for the finance company, because they are responsible for providing

portfolio data on obligor and collateral characteristics. Portfolio data can be used to determine

diversification and concentration advantages within the portfolio characteristics.

5.5.1 Obligor profile

The number of defaults in auto lease securitization is highly correlated to the financial health of

obligors or lessees (Fitch 2011; and Moody‟s, 2011a). They must ultimately provide the payment

stream to the financing company. The obligor profile is determined by the following indicators:

Obligor dollar concentration

Obligor credit score

Rating agencies examine lessee dollar concentrations or total amount of funding per lessee in order to

determine concentration risk and diversification benefits of the asset portfolio. The lessee dollar

concentration risk influences the amount of credit risk (Moody‟s, 2011). The lessee dollar

concentration provides information about the exposures to different customers (Moody‟s, 2011). Large

exposure to a few customers can significantly increase the amount of credit risk. A default of a large

customer can result in a big credit loss. Rating agencies are focused on the top one, top five and top

ten lessee concentration. Lessee dollar concentrations can be measured by:

Lessee dollar concentration

.

In the case of BFM, the obligor dollar concentration can be measured on two layers (see Figure 12).

BFM has relative large exposure to their direct customers (leasing companies). The current portfolio

only represents 17 leasing companies. Therefore, the obligor concentration risk on direct customers is

very high. The concentration risk of lease companies may have negative influence on the securitization

transaction. However, the second layer is much more diversified, because the concentration of end

customers is much lower. The stream of payments is thereby covered by a wider base of lessees than

only the leasing companies. This unique structure must be specifically investigated and assessed by

rating agencies in order to determine the ultimate assessment of lessee dollar concentration of the asset

portfolio.

A better interest expense rate is acquired by a customer base consisting of financially healthy lessees.

Therefore, it is important to examine the financial status and performance of the lessees. The average

financial health of the securitization customer base can provide a good indication of the frequency of

expected defaults in the underlying portfolio. It is therefore important that data on creditworthiness of

customers are maintained accurately. Credit rating agencies expect that originators apply an adequate

method to determine obligor credit scores. According to credit rating agencies, it is advisable to assign

a score to each customer in order to gain more insight in the credit score of customers (Fitch, 2011;

and Moody‟s, 2011).

At the moment, customers of BFM are screened by BFM in the following way. Per customer, a

business case is prepared based on information derived from a company visit. This business case is

presented to the risk committee in order to assess the risk of the customer and its business case. There

is no credit score assigned to each customer what makes it difficult to estimate and compare the

obligors credit risks.

Confidential

Confidential

Page 73: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

65 Master Thesis Vincent Bakker 21-03-2014

An example of a possible and common used internal credit score rating method is the Altman‟s Z-

score (Hull, 2010). The method is focused on the financial stability of business obligors. Five

accounting ratios are used to predict default likelihood in the near future. The Z-score is calculated by:

+ 1,4 + 3,3 + 0,6 , with

:

:

:

The height of the Z-score determines whether the obligor is likely to default. A Z-score above 3

indicates unlikely probability of default. A Z-score between 2,7 and 3 indicate a small chance of

probability. A Z-score between 1,8 and 2,7 indicates a good chance of probability. A Z-score below

1,8 indicate a very high chance of default. However, it is questionable whether it is possible to obtain

reliable key financial figures from customers.

5.5.2 Collateral quality

The characteristics and composition of the collateral of the securitized asset pool can have significant

impact on the asset correlation and thus the portfolio credit risk of a securitization (Fitch, 2011). Some

characteristics are directly related to credit losses, where others are related to the credit loss

performance. The collateral quality of the securitized portfolio will therefore be analysed by rating

agencies (Fitch, 2011; Moody‟s, 2011a; and S&P, 2011). To assess the quality of the collateral of the

asset portfolio, they examine the following indicators:

Vehicle mix dollar concentrations by:

o Segment

o Brand

o Model

Original lease term dollar concentration

Remaining instalments maturity

Lessee geographic dollar concentration

Lessee Industry dollar concentrations

The vehicle mix is a collection of characteristics of the collateral that have an impact on the credit risk.

The vehicle mix is focussing on the segment, brand and model characteristics of the underlying

vehicles (Fitch, 2011; and Moody‟s, 2011). Brand, model and segment can influence the value of the

underlying asset portfolio in the securitization, especially in the case of negative events. For example,

bankruptcy or recalls of single manufacturers can have an impact on the value of cars of that particular

brand or model. But also political and regulating changes can affect the residual value realization. For

example, if political changes make it more expensive to drive in SUV‟s while the asset pool exists of a

large amount of SUV‟s, this will put pressure on the residual value of the car. Large exposures to

single brands, models or segments can lead to an increase in residual value risk and credit risk

(Moody‟s, 2011). Insight into exposures of vehicle mix dollar concentrations can be calculated with

the following formulas:

Page 74: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

66 Master Thesis Vincent Bakker 21-03-2014

Segment dollar concentration

Brand dollar concentration

Model dollar concentration

The lease term of contracts can be divided into the original term and remaining term. The original term

is the agreed term of the contract. The remaining term indicates the time that is left of existing

contracts. Fitch (2011) has observed that the frequency and severity of defaults increase for longer

original term leases. This can be explained by the fact that longer terms make contracts amortizes

slower. This increases the loss severity in case of a default. In addition, originators must predict future

values or residual values further in the future, which increase the volatility of recovery and residual

value realization, and thus affect the amount of credit risk (Fitch, 2011). A good dispersion between

original terms can mitigate this risk.

Original term dollar concentration i

(i is the number of months).

The remaining term indicates the time that is left of existing contracts. In many securitization

transactions, the remaining term distribution can provide much information about the period when

contracts expire and will become due. It gives insight in the timing of instalment and final instalment

payments. Large final instalments exposures with the same remaining term can negatively influence

the cash flow structure. For example, if a large portion of the portfolio expires in the same time and

the wholesale market is in a weak condition, this can influence the residual value of the vehicles

(Moody‟s, 2011). In addition, this can result in substantial mismatch between assets receipts and

liability payments.

Remaining term dollar concentration i

(i is the number of months).

Industry concentration and geographical concentration provides insight into the exposures to a single

industry or a single region (Fitch, 2011; Moody‟s, 2011a; and Moody‟s, 2011b). Geographic

concentration of lessees can influence the exposure to regional economic downturns (Fitch, 2011).

Higher (than normal) concentrations of lessees in a certain region will result in an additional portfolio

risk. Well diversified asset portfolios mitigate the risk of regional economic downturns. Industry

concentration of lessees can influence the exposure to industry downturns. Higher (than normal)

concentrations of lessees operating in the same industry will result in an additional portfolio risk.

These indicators can be monitored by:

Geographic dollar concentration

Industry dollar concentration

5.5.3 State of car industry and market

The state of the car market is determinative for the actual value of the underlying assets in the

financial contracts. For credit risk, the LGD is depending on the current market value of the car at time

of the default event. The amount of LGD depends on the difference between the actual market value of

the car and the book value of the financial contract. In order to properly estimate the LGD, it is

important to monitor the development of the market value of the underlying cars. For residual value

Page 75: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

67 Master Thesis Vincent Bakker 21-03-2014

risk, the loss or gain is depending on the actual market value compared to the predetermined residual

value. An indicator to make this visible is the “loan to value” ratio.

In terms of BFM it is the ratio of the actual value of the financing contract and the actual value of the

market. However, this is strongly depending on determination of market values. The loan to value

ratio is currently tracked by two indicators, trading values and market values of used cars based on

auto telex23

. This is in turn split into value on book date and estimated residual value on end date.

There is already insight into the developments of loan to value ratio.

5.5.4 Macroeconomic conditions

The macroeconomic conditions can have a significant influence on the performance and quality of the

asset portfolio in the future. Economic downturns can have large impact on the value of the underlying

collateral, which could increase the amount of credit risk of the securitization. The macroeconomic

factors are taken into account by the rating agencies and are dependent on economic growth, interest

rates development, inflation rates and consumer confidence, and so on. Macroeconomic conditions are

independently incorporated in the credit rating decision.

5.6 Other rating drivers

In addition to credit risk and residual value risk, rating agencies have identified a number of other key

rating drivers that may influence the quality and credit rating of car related ABS transactions (Fabozzi

& Choudhry, Fitch, 2011; Moody‟s, 2011; and S&P, 2011):

Structural issues

Liquidity risk

Interest rate risk

Counterparty risk

Operational risk

Legal issues

In this study we pay limited attention to these risks. Nevertheless, it is good to understand what other

risks are involved besides the two key risks in the securitization of car financings. They may be

decisive whether the securitization transaction will be a feasible funding strategy.

5.6.1 Structural issues

A number of structural characteristics of the securitization transaction can have a direct or indirect

influence on the interest expense rate of a securitization transaction (Fitch, 2011; and Moody‟s, 2011).

Rating agencies consider the transaction liability structure, liquidity risk and interest rate risk. These

factors are taken into consideration in the stress tests used by the rating agencies to determine the final

credit rating.

Transaction liability structure

An important task in securitization transaction is the alignment of assets and liabilities of the issuing

entity (the SPV). This is strongly dependent on the repayment structure of cash payments to investors

(e.g. the difference between pay-through and pass-through repayment structures). The repayment

structure is the way in which the receipts and payments of the securitization transaction are structured

and timed and is an important aspect of the transaction structuring. According to Fabozzi & Choudhry

23 Auto telex is a common used car market and trading value tool.

Confidential

Page 76: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

68 Master Thesis Vincent Bakker 21-03-2014

(2004), it is important to match the cash flows generated by the asset pool with the cash flow required

for the repayment of interest and principal on securities issued.

During the term of the securitization transaction, receipts must be able to cover the amount to be paid

on issued securities. In addition, receipts from the asset pool are distributed throughout a period, while

payments on securities are usually made once a period. A best possible match must be made between

receipt and payments in order to reduce the risk of structural mismatch between receipts and payments

of the issuer. Also the height and choice between fixed and variable interest rates of receipts and

receivables may pose risk to the liquidity of the securitization. Besides that, the classification and size

of different tranches are decisive for the risk profile of tranches. The latter one is already explained in

Section 2.6.1. Other credit enhancements can also be used to reduce structural risk in the securitization

transaction.

In most auto lease securitization transaction, the originator (operating as servicer) may collect the

debtor payments and disposals of returned off lease vehicles into its own bank accounts before

transferring it to the accounts of the SPV (Fitch, 2011). Commingling refers to the number of days that

the collections are stored on the account of the originator before transferring it to the accounts of the

SPV (Fitch, 2011). To keep the structural risk of commingling as low as possible the number of days

that the collections are hold by the originator should be as low as possible. As the commingling

increases, the risk increase and more credit enhancement will be required by rating agencies (Fabozzi

& Choudhry, 2004; and Fitch, 2011).

Liquidity risk

In the case of car lease securitization a mismatch can occur in the timing of receipts and payments as

well as in different interest rates of receipts and payments. The timing of receivables and payments

may pose a risk to the liquidity of the securitization transaction. Liquidity risk in securitization

transactions is the inability of the issuer to meet its obligations and make cash payments as they

become due (Comptroller, 1997). In a securitization transaction, the obligations and cash payments to

investors are fairly predictable. However, cash receipts generated by the asset pool are less certain and

predictable, since they are affected by delinquencies and defaults. It may be possible that part of the

cash receipts are received to late or incomplete in order to make cash payments to investors. Adequate

and efficient planning of the payment structure can improve the liquidity of the securitization

transaction. The issuance of securities is used to finance the asset portfolio of the SPV. This means

that the SPV has the obligation to repay investors plus an interest amount. Such payments must be

generated by the asset pool. It is therefore necessary to receive the receipts in time.

Interest rate risk

Interest rate risk is the risk of a loss derived by a change in the variable interest rate. ABS transaction

securities are fixed-income securities. The interest rates on assets in the securitized portfolio are often

fixed interest rates. The interest price of ABS securities may fluctuate on general economic interest

rate changes. Investors are keen to be covered against the risk that their investments will decrease in

value by changing global interest rates, and therefore ask a variable rate depending on EURIBOR or

LIBOR rates24

. In some cases, the investor would prefer to receive a fixed rate for portfolio purposes.

However, generally, investors prefer to receive a floating rate on ABS to be covered against the

interest rate risks (Fabozzi & Choudhry, 2004).

24 Interbanking lending rates which are daily fluctuating.

Page 77: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

69 Master Thesis Vincent Bakker 21-03-2014

We have already introduced how the cash flows are generated by the customers through lease

contracts. The contractual rates of these lease contracts are fixed and determined by using an internal

revenue model. When these contracts are securitized in an SPV, the SPV will receive an interest cash

flow from the asset portfolio based on a fixed weighted average interest rate. The simplest way to

convert the revenues to investors is to issue securities with a fixed interest rate. In that case, the

interest rate risk is with the investors and will therefore demand a higher interest rate. When a floating

interest rate is used on the issued securities, the issuer (SPV) is exposed to interest rate risk. To hedge

against this risk, the issuer must enter into an interest rate swap (IRS). This has consequences for the

structure of the securitization transaction. The SPV has to enter into an interest rate swap with a swap

counterparty in order to convert the receiving fixed interest income into a floating interest cash flow.

This is displayed in Figure 25. A premium will be paid to the swap counterparty in return for the swap

structure.

Figure 25: Interest rate swap structure (example)

In order to attract the most investors, it is useful to issue floating-rate notes. This indeed means that the

issuer in the securitization transaction of BFM/C4L will be exposed to interest rate risk and an IRS

structure as displayed in Figure 25 must be used to cover the issuer against interest rate risk.

5.6.2 Operational risk

Operational risk is the risk of losses caused by inadequate or failed internal processes, people and

systems or from external events (Hull, 2010). As already mentioned in Section 2.3, securitizations

have to deal with a number of transaction participant. Thereby, the performance of a car lease

securitization is depending on the quality, stability and financial conditions of these transaction

participants (Fitch, 2011). All parties involved in the securitization transaction shall be taken into

consideration by the rating agencies in order to determine the operational risk involved in the

securitization transaction. In particular, the originator and servicer of the securitization transaction are

extensively analysed. Other transaction participants are less extensively analysed by the rating

agencies than the originator/servicer. The quality of other transaction participants is often considered

based on their credit rating. This process is often referred as due diligence. Due diligence in

securitization is the investigation and evaluation of a company‟s business and opportunities (Bing,

1996). This enables them to get insight and improve the transparency and information of originators.

The servicer is responsible for the operational performance of securitization transaction and the

underlying asset portfolio. Rating agencies consider three main factors in their analysis of the

originator/ servicer (Fitch, 2011):

Corporate performance; operational and financial stability

Quality and capabilities of the underwriting process

Quality and capabilities of the servicing operations

Page 78: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

70 Master Thesis Vincent Bakker 21-03-2014

Rating agencies have recognized that the performance of car lease securitization transactions is partly

dependent of the corporate performance of the servicer/ originator (Fitch, 2010). The corporate

performance is tested based on operational & financial stability and motivation of the originator for

the issuance of securitization. Originators/ servicers must clearly define a corporate overview of their

business processes, strategy, history and competitive position in the market, in order to make its

business easily understandable. Poor operational or financial strength can lead to a capped credit rating

(Fitch, 2010). It is therefore very important to make the company and its business understandable.

The company must have the capabilities to perform a securitization and must be financially sound.

There is a special focus on the corporate capabilities of origination and underwriting. These

capabilities and quality of the origination process and underwriting process are reviewed in order to

determine whether the selected portfolio is established in a proper way. This is preliminary based on

the underwriting channels, residual value setting policy and early terminations handling. Besides

underwriting capabilities, the originator/servicer must be capable of servicing the asset portfolio in a

proper way. In particular, credit rating agencies are focused on the ability to manage the remarketing

of returned or defaulted cars.

5.6.3 Legal & tax issues

Legal risks in auto lease securitizations can affect the cost-effectiveness of the securitization process

(IFC, 2004). Legal risk is the risk of legal aspects on the securitization transaction, especially

focussing on the isolation of the asset portfolio and the bankruptcy remoteness of the issuer (SPV).

The transparency of the legal aspects and characteristics of the securitization transaction is decisive for

the pricing and rating of the securitization. Legal issues in the structure of a securitization transaction

can have significant impact on the credit and residual risk of a securitization. On contract level there

are legal issues of contract structures and transaction documents. On a higher level, it involves the

legal isolation of the assets from the originator, the legal transfer of the assets to the issuing vehicle,

and tax status of the vehicle.

A number of structural characteristics and parties are involved in a securitization transaction through

various agreements. These agreements must be structured and documented correctly in order to avoid

problems in the future. The list below summarizes the main requirements for a legal feasible

securitization transaction (based on IFC, 2004).

The assets should be capable of being transferred (IFC, 2004).

The legal settlement in the event of default (Fitch, 2011).

The legal settlement of clauses (Fitch, 2011).

The ability to achieve a true sale transaction (IFC, 2004). The focus of rating agencies is on

the legal isolation of the asset portfolio, in order to prevent the SPV for bankruptcy and

insolvency of transaction participants, namely the originator of the asset pool (Fitch, 2011).

The transfer and sale of assets must be irreversible. To achieve that, agreed limited recourse

provision and covenants between parties in the securitization should be enforceable (IFC,

2004). Moreover, credit enhancement agreements should be enforceable to ensure the

bankruptcy remoteness of the issuer (SPV).

It must be possible to securitize the assets, without notifying the obligors (IFC, 2004).

The issuer should be able to enforce ownership rights on the securitized asset portfolio and, if

necessary, should be able to appoint a back-up servicer (IFC, 2004).

A portfolio with less standardized contracts with a lot of variations increases the legal

organizational effort of a securitization transaction (Fabozzi & Choudhry, 2004). Exceptions

Page 79: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

71 Master Thesis Vincent Bakker 21-03-2014

in financial contracts increase the legal risk of the asset portfolio. The greater the number of

exceptions, the more expensive it is to make the contracts legally covered.

The analysis of legal issues is partly based on the transaction legal counsel. A legal counsel provides

opinions to certain matters including the bankruptcy remoteness and enforceability of the issuer of the

securitization (Fabozzi & Choudhry, 2004).

The contracts of BFM have a two-layer structure, which may introduce some extra legal risks when

securitizing these assets. The redemption statement and third clause on the contracts provide additional

legal issues in the contracts and may have consequences for the legal feasibility of a securitization

structure. It is essential that the contracts in conjunction with the redemption statement and third

clause are also capable of being transferred.

Another important issue is the tax consequence of a securitization transaction. A key aspect of the

securitization structure is to define the relation between both the originator and issuer in terms of tax

consequence (IFC, 2004). It is important that the structure is arranged tax neutral to ensure that the

securitization transaction does not lead to much additional tax liabilities arising from the securitization

transaction, which would not occur without the transaction. In most cases, some tax costs will arise in

securitization transaction. However, it is essential to know them with certainty in advance of the

transaction in order to make a decision whether the cost can be considered as acceptable regarding to

the overall benefits of the transaction (ICF, 2004). Unexpected tax charges can be eliminated by

investigating the tax neutrality in the pre-securitization phase.

5.7 Conclusion In this chapter we have identified the key rating drivers that influence the cost-effectiveness of a car

lease securitization transaction. Rating agencies assess a securitization transaction based on the rating

drivers of the transaction. These two main key rating drivers for the car lease securitization transaction

of BFM are credit risk and residual value risk.

Credit risk: the risk that the obligor will default on its obligation to make periodically payments

under an agreed contract, resulting in a loss

Residual value risk: the risk that the value of the leased car at the end of the lease contract is lower

than the predetermined expected residual value at start date

For most part of the contracts, the level of credit risk is depending on a two layer structure. Through

the intervention of a leasing company, a credit loss occurs only in the case of a default of the customer

(leasing company) and a default of the end customer. This two layer structure provides an extra

guarantee for the credit risk of the portfolio. Only in the case of label lease, BFM is direct exposed to

credit risk of the end customer defaults.

The residual value loss is determined by the turn-in rate which is the percentages of non-defaulted

obligors that return their car to the lessor at lease end and residual value realization rate which is the

difference between the expected predetermined residual value and actual residual value at lease end.

All contracts contain a redemption statement with a predetermined residual value amount, whereby the

sale of the cars is guaranteed at the end of the contracts. The number of returned cars by non-defaulted

obligors is expected to be zero for BFM, because obligors are required to purchase the car according to

the redemption statement. The eventual loss of residual value is for the account of BFM, only if the

counterparty defaults on the final payment. The loss on residual value is therefore classified as credit

loss on the final instalment. These final instalments can be included in the securitization transaction by

a claim on the final instalment.

Confidential

Confidential

Page 80: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

72 Master Thesis Vincent Bakker 21-03-2014

On the basis of a number of variables that determine the level of credit risk and residual value risk, a

credit rating is derived from their rating models. The main variables are the probability of default,

recovery rate, asset correlation, turn-in rate and residual value realization rate. These variables are

estimated on the basis of the (data) input of the originator. Historical performance data of the portfolio

and influencing factors are used by the rating agencies to estimate the variables. These can be

measured by a number of indicators.

For BFM it is already of importance to get control and insight into the required input parameters in

order to obtain a good credit rating and price on the securitization transaction. Especially historical

performance database requires immediate attention, since rating agencies expect to receive 3 to 5 years

of historical performance data. In order to perform a cost-effective securitization transaction, it is

necessary to organise and define a large number of input and/or indicators that are determinative for

the quality of the securitization transaction. The framework in Figure 26 can be used to get control of

the quantifying variables and influencing factors & indicators that are used to determine the portfolio

credit risk and residual value risk. These are the two key rating drivers.

Key rating

drivers

Quantified by Influencing

factors

Indicators/ input

Credit

risk &

residual

value risk

PD

LGD (= (1-

recovery rate )*

EAD)

Maturity

Asset and default

correlation

Turn in rates

Residual value

realization rate

Historical

performance

Default rate

Delinquency rate

Recovery rate

LGD rate

Turn-in rates

Residual value realization rate

Obligor profile

Lessee dollar concentration

(customers and end customer)

Credit score

Financial key Figures

Collateral

quality

Vehicle mix dollar concentration

o Segment

o Brand

o Model

Lease term dollar concentration

o Original term

o Remaining term

Geographic and industry dollar

concentration

Industrial

conditions

Financing value to market value ratio

Macroeconomic

conditions

Economic growth, interest rates,

inflation rates, consumer confidence,

and so on Figure 26: Key rating driver quantification framework

Historical performance is a key input to determine expected future pool performances under various

scenarios, in particular payment behaviour of obligors. Rating agencies try to estimate a full

probability distribution of the expected credit loss of the pool and its variance, based on the estimates

of the expected credit loss and its variance. For BFM, the indicators default rates, delinquency rates

and obligor profiles of customers must be tracked on two layers, because both leasing companies and

end customers have an impact on the level of credit risk and residual value risk of the asset portfolio.

Confidential

Confidential

Page 81: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

73 Master Thesis Vincent Bakker 21-03-2014

Obligor profile and collateral quality are determinative for the financial health of obligors and quality

of the collateral in the asset portfolio. The composition of these factors is in control of the finance

company, and should be defined and organized well in order to get insight and control on the quality

of the portfolio.

Rating agencies are focussed on the two key rating drivers. However, other rating drivers should not

be underestimated. They can reduce the credit rating and increase the interest price if they are not

properly investigated by the originator or sponsor of the transaction. For completeness, we have also

created a framework (displayed in Figure 27) of the other rating drivers that can be used for control

and organization of the securitization transaction of BFM. These drivers are particularly interesting for

BFM in order to provide a clear overview of the complexity of the two layered funding structure of the

contracts.

Other rating

drivers

Influencing factors Indicators/ input

Structural

issues

Transaction liability structure

Repayment structure

Commingling

Credit enhancement

Liquidity risk Asset-liability mismatch

Interest rate risk Portfolio-funding interest rate

mismatch

Operational

risk

Corporate performance; operational

and financial stability

Financial key figures

Business processes

Business strategy

History

Competitive position

Quality and capabilities of the

origination and underwriting process

Origination process

Underwriting process

Quality and capabilities of the

servicing operations

Servicing process

Residual value setting policy

Early termination process

Legal & tax

issues

Contract structure and transaction

documentation

Legal settlement of defaults

Legal settlement of clauses

Transferability of assets

Level of standardization of contracts

Legal isolation of asset portfolio

Ability to achieve a true sale

transaction

Ability to enforce ownership rights by

issuer

Legal transaction counsel

Figure 27: Framework of other rating drivers

To ensure a well-organized securitization transaction for BFM, the indicators/ input parameters must

be clearly defined and well-organized in the business processes of BFM. This provides control of the

influencing factors, and thus control of the rating drivers of the securitization transaction. Control and

visibility on rating drivers can be seen as requirements for a cost-effective securitization.

This chapter has provided an answer to research question (4): What are the key rating drivers that

influence the cost-effectiveness of the car financing securitization program and how do you control

them?

Confidential

Confidential

Page 82: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

74 Master Thesis Vincent Bakker 21-03-2014

Chapter 6: Conclusion, recommendations & discussion This chapter contains the final conclusions of the research project, discussion of the reliability of the

results and recommendations for further steps. The first section outlines the conclusions by answering

the problem statement of the research. This section is followed by the recommendations for possible

further steps in applying securitization as a funding solution. This chapter ends with a discussion on

the strong & weak points of the study and the final value of the research.

6.1 Conclusion In this research we have investigated the possibilities of performing a securitization program as a

funding solution for the capital shortage problem of the finance company. Capital shortage can

possible limit the growth of the car financing asset portfolio of the finance company in the foreseeable

future. The main motivation for introducing a securitization funding strategy is raising capital to

ensure the continuation of funding support to BOVAG enterprises. The current funding capacity has a

maximum of €100 million (€15 million equity; €25 million internal debt; €60 million external debt)

The current portfolio value is about 25 million and does not cause shortage problems. However,

management expects a growth towards a size of € 100 million and more in about 3 to 5 years.

Securitization is considered as a possible alternative funding solution in order to eliminate this capital

shortage problem on the medium to long term.

In the beginning of this research project we have defined the following problem statement: “How can

securitization of car financing contracts be organized in order to raise capital in a cost-effective way

and what adjustments should be made in order to introduce a securitization funding strategy?” The

research has shown that the organization and structuring of a securitization turned out to be very

complex and transaction specific. There are a large number of organizational aspects that should be

considered when introducing a securitization funding strategy. We answer the research question by

mentioning the main important organizational characteristics for the securitization of the asset

portfolio of BFM, based on the findings in this research.

Portfolio composition and transfer to SPV

The organization of a securitization transaction starts with the identification of the asset portfolio of

BFM. The portfolio must meet a number of requirements in order to raise cost-effective capital

through a securitization funding strategy. The main requirements that the assets must meet are being

regular & predictable cash flow generating assets and must be transferable. This is a prerequisite for

the securitization of the asset portfolio, because the assurance of the future generated cash flow by the

asset pool is determinative for the risk of repayment of investors in securities. In addition, the

contracts must be standardized in order to reduce the legal issues when transferring the asset portfolio

in a securitization transaction. Too many exceptions to standardized contracts will increase the legal

risk and complexity of the securitization transaction, making it less cost-effective. Diversification of

the asset portfolio is the basis of obtaining a high credit rating on the securitization transaction. It is

important to have a well-diversified portfolio on a number the following aspects: Lessee dollar

concentration, vehicle mix dollar concentrations, original lease term dollar concentration, remaining

instalments maturity, lessee geographic dollar concentration and lessee Industry dollar concentrations.

The credit rating and cost-effective deal size is depending on the degree of diversification on these

aspects. Ultimately, the assets that qualify for securitization must also meet the following eligibility

criteria:

The first lease payment must be made (1 month seasoning)

Confidential

Page 83: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

75 Master Thesis Vincent Bakker 21-03-2014

No receivables more than 30 days or 60 days past (delinquent)

No lessee can be in a bankruptcy procedure

Contracts must contain legal settlements for clauses and event of defaults

The organization of the securitization transaction will require the introduction of an SPV. The SPV is

used to organize the securitization transaction as bankruptcy remote as possible. The bankruptcy

remote feature is used to separate the SPV entity from BFM in case the finance company enters into a

bankruptcy procedure. This ensures that creditors (of BFM) can have no possible claim against the

SPV, in case of bankruptcy of the finance company, due to the isolation of the asset portfolio from the

originators balance sheet. This can be achieved by a true sale of the asset portfolio, in which the SPV

becomes the legal owner of the assets. The issuer (SPV) should be able to enforce ownership rights on

the securitized asset portfolio.

It turned out that the asset portfolio of BFM/C4L exists of financial lease contracts to business

customers and operational lease contracts to business customers. The portfolio may be expanded by

the following contracts: operational lease contracts to private customers, financial lease/ hire-purchase

to private customers and car (consumer) loans. Although there are small structural differences between

customer types, all contracts (assets) meet the definition requirements of securitization. They generate

a regular and predictable cash flow with a car as collateral. An important organizational aspect of

securitizing car lease assets is the transfer of the legal title of the car. When the portfolio is securitized,

the legal title of the car must be transferred to the SPV in order to ensure that the legal ownership is

isolated from the BFM and no claims can be made on the asset by any creditor in case of a bankruptcy

procedure of the finance company. In operational lease, the underlying assets (car) or economic

ownership must also be sold to the SPV in order to isolate the residual value realization from the

originator. Both transfers provide a bankruptcy remote structure, which is necessary for cost-effective

securitization. Due to the fact that the pool of assets is separated from the bankruptcy risk of BFM, it

has the potential to ensure much lower funding costs. The isolation of the assets enables the finance

company to increase the creditworthiness of the asset portfolio.

The process of transferring the legal title of the car can be time-consuming and costly. This can be

improved by adding a titling trust in the organization of a securitization transaction. A titling trust can

be used to hold the vehicle title and leases from the beginning of the underwritten lease contract. BFM

will not be listed on any title, but has an undivided beneficial interest (UTI) in all leases and related

vehicles. BFM will be contractually engaged as a servicer of the titling trust. When a securitization

actually takes place, the titling trust will issue certificates that represent a special unit of beneficial

interest (SUBI) on the assets to be securitized, which are sold as a true sale to the securitization trust or

SPV. No transfer of titles is needed and the vehicle ownership and lease contracts remain with the

titling trust. Only the SUBI certificates and the associated rights are transferred to the securitization

SPV.

Choice of asset backed securitization structure

The choice of the securitization structure determines how the securitization transaction should be

organized. We have investigated four main true sale securitization structures that are suitable for the

asset portfolio of BFM: Master trust structure, grantor trust structure, owner trust structure and

ABCP conduit structure. An assessment model is used to determine which structure best suits the case

of BFM. This is based on three criteria:

flexibility

certainty

Confidential

Page 84: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

76 Master Thesis Vincent Bakker 21-03-2014

cost-effective deal size

The analysis and assessment showed that participating in a multi-seller ABCP conduit is the most

suitable structure to organize a securitization funding strategy in a cost-effective way for BFM.

Participating in a multi-seller ABCP conduit has the advantage of having a much lower cost-effective

deal size, which can even fall within the capital capacity (€100 million) of BFM. Moreover, the multi-

seller ABCP structure scored also well on flexibility, because the conduit funding can be used on an

on-going basis (warehousing), allowing the portfolio to grow to a larger portfolio volume within the

same securitization structure. Nevertheless, multi-seller ABCP score relative low on the certainty

criteria. Medium-term assets of BFM will be financed with short term commercial paper which results

in a mismatch of assets and liabilities. Periodically new commercial papers should be issued or rolled

over to ensure the continuity of funding. However, this is an uncertain factor due to the fact that

investors may not will to refinance their investments in short term commercial paper.

Within the foreseeable future, the other structures (master trust, owner trust structures and grantor

trust) are less interesting based on their large cost-effective deal sizes. The relative high additional

costs of securitization can only be covered by large portfolio volumes (€150-200 million is the

minimum cost-effective deal size). Nevertheless, these structures provide a more secure form of

funding than ABCP. In the long term, it may be beneficial to switch from an ABCP structure to a more

secure long term funding form. In that case, a master trust is preferred over owner and grantor trust

structures, since it provides more flexibility and has the ability to reuse the structure for additional

securities issuances (which can also reduce costs). However, the portfolio must therefore grow

significantly to remain cost-effective. The capital limit ensures that participating in a multi-seller

ABCP is the first step to securitize the asset portfolio of BFM.

Organization and control of (key) rating drivers

For the use of a securitization as a funding strategy, it is important to understand and get control on

the rating drivers that determine the quality and interest on issued commercial paper or securities of

the securitization transaction. Insight and control of rating drivers assist in organizing various

processes to be well prepared for the implementation of a securitization funding strategy. We have

investigated the key rating drivers examined by credit rating agencies. The two key rating drivers are

credit risk and residual value risk

Credit rating agencies use the level of credit risk and residual value risk to determine a loss

distribution and credit worthiness of the securitized portfolio of car financing assets, depending on the

variables probability of default, recovery rates, loss given default, asset maturity & correlation, turn-in

rates and residual value realization rates. They determine these variables on the basis of historical

portfolio performance and influencing factors. These influencing factors are obligor profile, collateral

quality, industrial conditions and macroeconomic conditions. Obligor profile and collateral quality

should be organized and provided by BFM in terms of indicators.

In order to obtain a good rating it is important to get control of the influencing factors and indicators

that determine the level of credit risk and residual value risk. Obligor profile and collateral quality are

the two main influencing factors for BFM, since rating agencies expect to receive all relevant data on

these two factors from the finance company. Therefore, BFM is required to keep control of data of at

least 3-5 years on the following indicators of obligor profile: Lessee dollar concentration (customers

and end customer), credit scores of obligors, and financial key figures of obligors. For the collateral

quality, the indicators are: vehicle mix dollar concentration (segment, brand, model), lease term dollar

concentration (original term, remaining term), geographic and industry dollar concentration.

Confidential

Confidential

Page 85: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

77 Master Thesis Vincent Bakker 21-03-2014

The basis for credit loss analysis and estimation are the historical portfolio performance data, derived

from the portfolio loss data and the static pool loss data. Portfolio loss data is simply the losses that

occur in each period as a percentage of that periods‟ outstanding portfolio balance, which composition

is changing over time and can be calculated by the conditional default rate (CDR). This provides

insight in the proportion of leases in the portfolio that has gone into default as percentage of the total

value of the portfolio. A static pool loss data is an isolated static subsets of originated contracts and

used for a detailed tracking of its performance of the contracts over time and can be calculated by the

cumulative default rate (CDX). This provides insight in the development of defaults per month on an

annualized basis.

Next to the key rating drivers, a number of other rating drivers may be decisive for the cost-

effectiveness of the securitization transaction. These are structural, legal and tax issues, and

operational risk. Therein, it is important to define business processes, origination, underwriting and

servicing structure.

Rating agencies are focussed on the two key rating drivers. However, BFM may not underestimate the

other rating drivers. They can reduce the credit rating and increase the interest price if they are not

properly investigated by the originator or sponsor of the transaction and may be decisive for the cost-

effectiveness of the securitization transaction. The other rating drivers are structural, legal and tax

issues, and operational risk. These drivers are particularly interesting for BFM in order to provide a

clear overview of the complexity of the two layered funding structure of the contracts. It is necessary

to make these drivers transparent for the assessment of the securitization transaction.

6.2 Recommendations In this study, we examined not only how securitization can be organized as a funding strategy for

BFM, but also what adjustments need to be made to implement securitization as a funding strategy.

The following recommendations are made in order to facilitate the introduction of a securitization

transaction.

Start keeping record of historical performance data and portfolio data on two layers.

Data management is one of the key requirements to ensure a proper securitization transaction. The

rating agencies expect to receive at least 3 to 5 years of historical performance data of the portfolio of

defaults and delinquencies. A compelling recommendation is to improve the data process and control

on (historical) payment behaviour of customers & end customers and portfolio characteristics. This

facilitates not only a potential future securitization transaction, but also provides more insight in the

portfolio characteristics and performance.

To obtain visibility in the portfolio performance, it is advisable to separate the data on the two layers

of customers and end customers. This enables the finance company to make the payment behaviour

insightful on both layers. The payment performance of the customer layer is visible for all type of

contracts for BFM, because they pay directly to C4L/BFM. Any delinquency or default is visible for

BFM and can be stored in a database. The visibility in payment performance of end customers is

depending on the type of customer. In case of label lease and funding & management customers, the

customer portfolios are managed by C4L. This ensures that the finance company has visibility in

payment behaviour of end customers and data can be stored in a database. However, in the case of

(solely) funding customers, BFM does not have the visibility in payment behaviour of end customers,

since the contract portfolio of the customer is managed by the customer himself. For the acquisition of

Confidential

Confidential

Page 86: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

78 Master Thesis Vincent Bakker 21-03-2014

data, the finance company is dependent on the customer. Therefore, a solution must be found to

collect all data at BFM.

Choose an ABCP sponsor partner to gain more insight in costs and gains of the potential

securitization funding strategy.

The research results indicate that participating in a multi-seller conduit or ABCP of a large commercial

bank (sponsor) is the best suitable funding solution for BFM. However, it turned out that these parties

are reluctant to disclose certain key information such as specific costs of securitization transactions,

because they do not have all inside information on the potential securitization deal. To be sure that

participating in a multi-seller conduit is a cost-effective funding strategy for BFM, there should be

more clarity obtained on the costs involved of the sponsor.

A compelling recommendation is to choose a party that will be the sponsor of the ABCP conduit for

further preparation for a securitization transaction. By choosing a sponsor of a multi-seller and sharing

information of the potential deal, it is possible to gain more insight into the possibilities of a

securitization transaction for BFM. In particular, the costs and thus potential cost-effectiveness of a

securitization transaction is important. This can help to determine whether securitization is indeed a

cost-effective way of funding for BFM.

Defining and control the business processes, obligor profiles and collateral quality, and ensure that

necessary data is available.

An important condition for obtaining a good credit rating on the securitization transaction is the

understandability of the business processes. Rating agencies require to receive a clear description of

the origination, underwriting and servicing process, and capabilities of the finance company.

Therefore, we recommend to clearly define these processes, so that they are understandable to third

parties. The framework of Figure 27 can be used as a guideline to organize this. We advise to use

standardized processes as much as possible, to reduce the complexity of a potential securitization

transaction.

Both obligor profile and collateral quality are in control of BFM/ C4L. They choose their customers

and approve financing of underlying collateral. The quality of both is determined by the finance

company. Since the quality is determined by the originator of the asset portfolio, rating agencies

require visibility in the portfolio details. In order to ensure high quality input for credit rating agencies

on portfolio details, a compelling recommendation is to define obligor profiles according to a standard

approach such as Altman‟s Z-score mentioned in Section 5.5.1 or a comparable approach and record

obligor profiles into a data file. A standardized approach for the determination of financial health of

obligors, ensure that the average financial health of obligors in the asset portfolio can be determined

and compared by rating agencies. In addition, we recommend keeping track of the characteristics of

the collateral in the asset portfolio as mentioned by the key rating framework indicators, which can be

used to determine the various concentrations and collateral quality of the asset portfolio.

Further research

In this research we have not paid equal attention to all aspects of a securitization transaction. In

particular, legal and accounting & tax issues are not extensively explored. This study provides only

limited insight into the feasibility of securitization based on these aspects. We recommend to examine

these aspects into more detail in order to ensure that securitization is also legally feasible for the

finance company of BFM.

Confidential

Page 87: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

79 Master Thesis Vincent Bakker 21-03-2014

6.3 Discussion

Although our findings seem to be convincing, we must make conclusions with some caution.

Securitization turned out to be a complex playing field of structured finance, in which many issues

play a role in the process. Moreover, every securitization transaction differs from one other, making it

difficult to work from a basic concept. Legal issues, financial issues, structural issues, risk issues,

counterparty issues, accounting issues and more should be considered in detail when introducing a

securitization funding strategy. The complexity of securitization is also reflected in the literature.

Some papers discuss all aspects, but are often too general and do not provide in depth research.

Frequently, studies are focussed on one or a few aspects of securitization to go into detail. Moreover,

we found out that the consistency between various studies in the literature is rather weak. Many

aspects of securitization are interpreted and defined differently in various papers. We have chosen to

define securitization as a generic term in order to gain knowledge about securitization in general in

Chapter 2. Subsequently, we have focussed on structural issues, financial issues and risk issues in

detail, which lies in the extension of our expertise on financial and risk issues. However, we did not

pay much attention to the legal structuring, accounting & tax issues and other relevant issues. These

issues may be of serious concern for introducing a securitization funding strategy.

Initially, we focused on self-contained securitization programs (master trust, owner trust and grantor

trust securitization structures), in which capital is raised from capital markets solely based on the asset

portfolio of the finance company. In particular, the theoretical section (Chapter 2) is primarily based

on these structures. However, we found out that the large cost-effective deal size is a major constraint

of self-contained securitization programs. As we continued the research, we have searched for

alternative securitization solutions. We found out that it might be more interesting to participate in a

multi-seller asset-backed commercial paper securitization program of a large bank.

In this study, we have made statements about the expected development of the portfolio of the finance

company. Although we have discussed this carefully with the management, it is questionable whether

the prediction is valuable and reliable. Descending or ascending markets may slow or accelerate the

growth of the portfolio. However, a strong point of this research is that the assessment model and

rating driver framework can be applied to multiple scenarios of future developments. The various

structural options can be re-weighted when the expected portfolio development or motivation for

securitization will change.

A point of discussion is the added value and reliability of the calculated cost-effective deal size. The

cost-effective deal size model is depending on a large number of input parameters. A part of these

parameters are set based on the actual value from the market or finance company. However, some

parameters are estimated based on assumptions. This applies in particular to the estimation of the costs

of securitization. It turned out that it is difficult to accurately estimate these costs in this early pre-

securitization phase for a specific car-related financing securitization transaction. We have estimated

the costs of securitization based on the basis of expert‟s opinions. However, it is questionable whether

they are a good estimation, because it is limitary verifiable by literature studies. Moreover, banks and

securitization sponsors are reluctant to disclose their own fees. We are not able to say with certainty

that this is the true cost-effective deal-size for BFM.

Page 88: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

80 Master Thesis Vincent Bakker 21-03-2014

Reference list Altman, E.I., (1968). Financial ratios, discriminant analysis and the prediction of corporate

bankruptcy. Journal of Finance, 23, 589-609.

Brealey, R. A., Myers, S. C., & Allen, F. (2008) Principles of corporate finance. New York, The

McGraw-Hill Companies Inc.

Caprio, G., Demirgüc-Kunt, A., & Kane, E., J. (2008). The 2007 meltdown in structured

securitization. The world bank, development research group.

Carey, M., & Stulz, R. M. (2007). The risks of financial institutions. Chicago: The university of

Chicago press.

Covitz, D. M., Liang, N., & Suarez, A. S. (2009). The evolution of a financial crisis: Panic in the

assets-backed commercial paper market. Finance and economics discussion series (FEDS).

De Backer, A., (2009). Effectisering, juridische technieken en beleggersbescherming. Faculteit

rechtsgeleerdheid, Universiteit Gent.

De Coninck, M., (2009). Effectisering en het risicoprofiel van banken. Faculteit economie en

bedrijfskunde, Universiteit Gent.

DeMarzo, P., M., (2005). The pooling and tranching of securities: a model of informed intermediation.

Review of Financial Studies, 18, 1-35

Doff, R., (2005). Economic capital voor verzekeraars. MAB, pp. 582-589

Fabozzi, F. J., & Choudhry, M. (2004). The handbook of: European structured financial products.

Hoboken, New Jersey: John Wiley & Sons.

Fabozzi, F. J., Davis, H. A., & Choudhry, M. (2006). Introduction to structured finance. Hoboken,

New Jersey: John Wiley & Sons.

Fabozzi, F. J., & Kothari, V. (2007). Securitization: The tool of financial transformation. Working

paper, Yale international center for finance. [http://ssrn.com/abstract=997079]

Feng, X., & Long, Z. (2010). Auto loan-backed securitization in China. Advanced computer control

(ICACC), 4, 368-370

Haan de, J., Amtenbrink, F., (2011). Credit Rating Agencies. De Nederlandsche Bank (DNB), working

paper.

Hull, J. C., (2010). Risk management and financial institutions. Boston: Pearson

Page 89: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

81 Master Thesis Vincent Bakker 21-03-2014

Gangwani, S. (1998). Speaking of securitization. New York: Deloitte & Touche. Vol 3

Gorton, G. B., & Souleles, N. S. (2007). Special purpose vehicles and securitization. In Carey, M. &

Stulz, R. M. (eds.), The risks of financial institutions (pp. 549-602). Chicago: University of

Chicago Press. [http://papers.nber.org/books/care06-1]

Groeneveld, E., (2008). Onderzoek naar de mogelijkheden voor CMBS na de subprime crisis.

Amsterdam School of Real Estate.

Gupta, R. R., Edwards, E., Petu, D., Amador, I., Sancartier, J., & Bella, J. (2007). Rating U.S. auto

lease-backed securitizations: An update. Fitch Ratings.

Jobst, A. (2005). Asset securitization as a risk management funding tool: what does it hold in store for

SMEs? International Monetary Fund (IMF).

Kacperczyk, M., & Schnabl, P., (2010). When safe proved risky: Commercial paper during the

financial crisis of 2007-2009. Journal of economic perspectives, 24, 29-50

Kane, G., D. (1997). The problem of how to account for asset securitization transactions. Journal of

accounting education, 15, 39-51

Klee, N. K., & Butler, C. B., (2002). Asset-backed securitization, special purpose vehicle and other

securitization issues. Uniform Commercial Code Law Journal, 35(2), 23-68.

Litwin, S. M., & Levy, W. A. (2000). New developments in equipment and auto lease financing:

securitization, leveraged leasing and titling trusts. In (2nd

ed.), Equipment leasing – leveraged

leasing. Aspen: Aspen Law & Business.

Malamud, S., Rui, H., & Whinston, A. B. (2013). Optimal incentives and securitization of defaultable

assets. Journal of financial economics, 107, 111-135

Mansini, R., & Speranza, M.G. (2002). A multidimensional knapsack model for asset-backed

securitization. Journal of the operational research society, 53, 822-832.

Martínez-Solano, P., Yagüe-Guirao, J.,& López-Martínez, F. (2009). Asset securitization: effects on

value of banking institutions. The European journal of finance, 15, 119-136

Pirotte, P., Schmit, M., Vaessen, C. (2004). Credit risk mitigation evidence in auto leases: LGD and

residual value risk. Solvay business school.

Sabarwal, T. (2006). Common structures of asset-backed securities and their risks. Journal of

Corporate ownership & control, 4, 258-265.

Page 90: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

82 Master Thesis Vincent Bakker 21-03-2014

Sarkisyan, A., & Casu, B. (2013). Retained interest in securitisations and implications for bank

solvency. European Central Bank, working paper

www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1538.pdf

Schmit, M. (2004). Credit risk in the leasing industry. Journal of banking & finance, 28, 811-833

Segoviano, M., Jones, B., Lindner, P., & Blankenheim, J. (2013). Securitization: lessons learned and

the road ahead. International Monetary Fund, working paper

Sullivan, D. (1998). Note: Why does tax law restrict short-term trading activity for asset securitisation.

Virginia tax reviews, 17, 610-655.

Tavakoli, M. T. (2008). Structured finance and collateralized debt obligations (2nd

ed.). Hoboken,

New Jersey: John Wiley & Sons.

Vink, D. (2009). Securitizatie: Hoe nu verder. Magazine for accountancy and business economics,

215-223.

Vink, D., & Thibeault, A. E. (2009). Securitizatie: een vergelijkende empirische analyse tussen

hoofdcategorieën ABS, MBS en CDO. Kwartaalschrift Economie, 4, 415-447.

Vink, D., & Thibeault, A. E. (2010). Securitization back to basics replacing humpty-dumpty. The

financial executive, 48, 16-21.

Zhang, J., Zhu, F., & Lee, J. (2008). Asset correlation, realized default correlation, and portfolio

credit risk. Moody‟s KMV

Additional references

Bank for International Settlements (BIS), (2008). Credit Risk Transfer. Basel committee on banking

supervision.

Bank for International Settlements (BIS), (2009). Report on special purpose entities. Basel committee

on banking supervision.

Bank for International Settlements (BIS), (2011). Report on asset securitisation incentives. Basel

committee on banking supervision.

Black Rock, (2011). Understanding ABCP: A primer. Blackrock

Page 91: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

83 Master Thesis Vincent Bakker 21-03-2014

Committee of European Banking Supervisors (CEBS), 2010. Guidelines to article 122a of the capital

requirements directive.

https://www.eba.europa.eu/documents/10180/106202/Guidelines.pdf

De Nederlandsche Bank (DNB), (2005). Statistisch bulletin juni 2005. Amsterdam: De Nederlandsche

Bank N.V.

Bank for International Settlements (BIS), (2008). Credit Risk Transfer. Basel committee on banking

supervision.

De Nederlandsche Bank (DNB), (2009). De invloed van securitisaties op de statistieken. Statistisch

bulletin juni 2005. Amsterdam: De Nederlandsche Bank N.V.

European Central Banks (ECB), (2007). The use of portfolio credit risk models in central banks.

Fabozzi, F. J. (2000) Investing in asset-backed securities. Pennsylvania, FJF

Global Credit Rating Co (GCRC) (2013). Global asset backed commercial paper (ABCP) criteria.

Johnson, J.W., & MacIvor, A. (2012). Taxation of financial asset securitization investment trusts

Price Waterhouse Coopers (PWC), (2006). Structuring securitisation transactions in the Netherlands

Telpner, J. (2003). A securitisation primer for first time issuers. Greenberg traurig, Global

securitisation and structured finance

Universiteit Twente (2012). Master thesis syllabus Industrial Engineering and Management (8th ed.).

University of Twente, Enschede, the Netherlands

Vereniging Nederlandse Autoleasemaatschappijen (2012). vehicle leasing market in Figures 2012.

Vereniging Nederlandse Autoleasemaatschappijen (VNA).

Wang, S., (2007). True sale securitization: Germany and China. VDM. Master thesis

Credit rating agency reports and requirements

DBRS, (2013). Asset-backed commercial paper criteria report: U.S. European ABCP conduits

DBRS, (2010). Rating U.S. auto lease securitizations

Fitch Ratings (Fitch), (2012). Global rating criteria for asset-backed commercial paper.

Fitch Ratings (Fitch), (2011). Criteria for rating U.S. auto lease ABS.

Page 92: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

84 Master Thesis Vincent Bakker 21-03-2014

Fitch Ratings (Fitch), (2006). European consumer ABS rating criteria

Fitch Ratings (Fitch), (2001). Asset-backed commercial paper explained.

International Finance corporation (IFC), (2004). Securitization key legal and regulatory issues.

Mezzanotte, C. J. (2013). Rating European consumer and commercial asset-backed securitisation.

DBRS ratings bureau.

Standard‟s & Poor (S&P), (2011). ABS: revised general methodology and assumptions for rating U.S.

ABS auto lease securitizations.

Standard‟s & Poor (S&P), (2012). Special report auto ABS.

Standard‟s & Poor (S&P), (2012b). Solvency II could push European insurers away from

securitizations.

Standard‟s & Poor (S&P), (2013). European auto ABS index report Q2 2013: Performance still

reflects Europe‟s economic recovery.

Moody‟s investor service (Moody‟s), (2003). The fundamentals of asset-backed commercial paper.

Moody‟s investor service (Moody‟s), (2011a). Moody‟s approach to rating auto lease securitizations.

Rating methodology

Moody‟s investor service (Moody‟s), (2011b). Moody‟s approach to rating fleet lease-backed ABS.

Page 93: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

85 Master Thesis Vincent Bakker 21-03-2014

Appendices

Appendix 1: Simplified organization structure

Figure 28: Organization structure of the Bovemij Verzekeringsgroep (BVG)

All business units are 100% owned by their parent company, unless otherwise stated.

BOVAG is for 83,12% owner of the Bovemij Verzekeringsgroep and is an inter-branch

organisation of entrepreneurs who are dealing with mobility, existing of circa 11.000 affiliated

entrepreneurs.

Stichting Administratiekantoor Bovemij Verzekeringsgroep (STAK) are (circa 260)

shareholders of the Bovemij Verzekeringsgroep N.V. for 16.88%.

Appendix 2: Different lease types

Car fleet management: The leasing company is responsible for the management of cars owned by the

customer.

Financial lease: type of lease in which the lessor stays the legal owner of the leased equipment. The

lessee is the economic owner and responsible for the insurance, maintenance and enjoyment of the

equipment. The customer bears the risk of residual value losses.

Net operational lease: type of lease in which the lessor is the legal and economic owner of the

equipment and only includes depreciation and interest. Maintenance, winter tires, etc. are costs for

lessee.

Operational lease close end: type of lease in which the lessor is the legal and economic owner of the

equipment. The lessor is responsible for maintenance of the equipment. In a closed end operational

lease, the leasing company bears the risk of residual value losses.

Operational lease open end: type of lease in which the lessor is the legal and economic owner of the

equipment. The lessor is responsible for maintenance of the equipment. In an open end operational

lease, positive residue of lease fees, depreciation and maintenance costs during the contract term, are

divided between customer and leasing company.

Page 94: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

86 Master Thesis Vincent Bakker 21-03-2014

Hire purchase: type of lease with a credit shape that is different from leasing. It is a credit shape in

which is some equipment is hired for an agreed period, in which the equipment is transferred to the

lessee after the last payment is made. It is comparable to financial lease.

Appendix 3: Funding and portfolio

Funding of Bovemij Financieringsmaatschappij:

Figure 29: Company balance sheet (simple) and funding properties. (Source: Monthly report BFM 09-13)

Appendix 4: Synthetic securitization The legal form of synthetic securitizations differs from the true sale ABS. A synthetic structure is

focussed on transferring the credit risk, instead of selling the assets itself. This is done through

entering into a credit default swap (CDS) with an SPV (DNB, 2009). In case of a default in the asset

portfolio, the SPV will guarantee the losses experienced by originator. In exchange, the originator will

pay a periodic CDS premium payment to the SPV. In turn, the SPV sells securities (credit linked

notes) to investors against an interest rate that is based on the periodic payment of the originator. The

proceeds received from investors are used to compensate losses in case of default. This will reduce the

returns of investors. On the other hand, investors can profit from a well performing asset portfolio and

obtain interest, repayment and premiums after deduction of the compensated losses (DNB, 2009). An

example of a synthetic securitization structure is displayed in Figure 30.

Figure 30: Synthetic securitization structure

One of the main objectives of the legal structuring aspects is to isolate the asset portfolio‟s credit risk

from the originator‟s credit risk. That isolation is needed as a precondition of achieving a higher credit

quality on the securitized portfolio (Fabozzi & Choudhry, 2004). In the case of a synthetic structure,

the originator buys protection from an SPV to reduce its exposure to credit and interest rate risk.

Financieringen 78% 23.488 Eigen vermogen 5.657 19%

Achtergestelde leningen - 0%

Funding 23.419 78%

Overige activa 22% 6.701 Overige passiva 1.113 4%

30.189 30.189

* Enkelvoudige balans Bovemij Financierinsgmaatschappij B.V. (€ x 1.000)

Funder

Type Startdatum Einddatum Faciliteit Saldo Resterend Type Huidig Tot

N.V. Schadeverzekering-Maatschappij Bovemij R-C 1-9-2012 Geen 5.000 3.559 1.441 Variabel 3,0% 31-12-2013

N.V. Schadeverzekering-Maatschappij Bovemij Tranches 85% 1-3-2013 Geen 15.000 11.321 3.679 Vast 2,1% + IRS 31-12-2013

ING Lease (Care4Lease) Tranches 85% - - 0 8.540 0 Vast - -

20.000 23.419 5.121

Balans Bovemij Financieringsmaatschappij*

Funding - Faciliteiten

Kredietfaciliteit (€ x 1.000) RenteContract

Confidential

Page 95: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

87 Master Thesis Vincent Bakker 21-03-2014

The most important need and motivation of BFM for securitization is to acquire liquidity or capital to

continue business activities. ABS and ABCP structures provide a new source of funding and raise

capital by a true sale transaction of its portfolio. In synthetic structures, originators do not sell their

asset portfolio and do not raise capital (Fabozzi & Choudhry, 2004). In addition, CDS premiums have

to be paid to the SPV. Synthetic structures do not have the potential to provide lower funding costs,

instead of ABS and ABCP that do have the potential to lower the funding costs. BFM does not matter

whether the assets are placed on- or off balance and thus which structure is chosen based on this

motivation. Solely based on the need and motivation for securitization the true sale structures, ABS

and ABCP, are suitable securitization structures. Meanwhile, synthetic structures are more relevant for

risk transferring instead of source of funding to raise capital. Therefore a synthetic structure will not be

an appropriate securitization structure for BFM.

Appendix 5: Credit ratings by different rating agencies

Figure 31: Comparison table of credit ratings from Moody's, Fitch & S&P25

Appendix 6: Calculation of portfolio growth The in order to calculate the book value of outstanding portfolio we used the following assumptions:

Contracts have an average initial financing value of €15.000 (which is conservative compared

to €17.582,92 which is the current initial average financing value of the contracts)

Average original lease term of 3 years (which approximately come close to the current

average original term of 33,1 months).

The percentage of redemption payment is set at 45% (which is comparable to the current

percentage).

2014 calculation examples:

In 2014 there are 3400 outstanding contracts with an initial value of €15.000 * 3400 =

€51.000.000

3400-1350= 2050 new contracts have a book value of € 15.000*2050 = € 30.750.000

1350 1 year-old contracts have a remaining term of 2 years. The value is split up in an

amortization part and residual value part. Therefore the book value is (1-0,45* €15.000*(2/3)*

1350 + 0,45*€15.000*1350 = €20.250.000

Total book value in 2014 is € 30.750.000 + €20.250.000 = €47.287.500

25 Source: The wall street journal

(http://online.wsj.com/news/articles/SB10001424052970203914304576630742911364206?mg=reno64-

wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052970203914304576630742911364206

.html dd. 20-12-2013)

Confidential

Page 96: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

88 Master Thesis Vincent Bakker 21-03-2014

2016 calculation examples:

In 2016 there are 8750 outstanding contracts with an initial value of €15.000 * 8750 =

€131.250.000

8750-2050-2675= 4025 new contracts have a book value of € 15.000*4025 = € 60.375.000

2050 1 year-old contracts have a remaining term of 2 years. The value is split up in an

amortization part and residual value part. Therefore the book value is (1-0,45* €15.000*(2/3)*

2050+ 0,45*€15.000*2050 = €32.768.750

2675 2 year-old contracts have a remaining term of 1 year. The value is split up in an

amortization part and residual value part. Therefore the book value is (1-0,45* €15.000*(1/3)*

2050+ 0,45*€15.000*2050 = €19.475.000

The total book value is € 60.375.000 + €32.768.750 + €19.475.000

Appendix 7: Revenue model of BFM

The interest rate of financial lease contracts of C4L is determined on a couple of fixed and variable

parameters. Basically, this is based on three parts and based on the weighted average cost of capital

(WACC) formula. The first component is the costs of debt, which is part of the funding of the contract

that is financed with debt. This component must cover the cost of debt from BFM. This weighted

interest rate is passed on to the customer. The second component is the cost of equity, which is the part

of the funding of the contract that is financed with equity. This component must cover the return on

equity that is required for the business unit. This weighted interest rate is also passed on to the

customer. In addition to covering the cost of equity and debt capital, the third component covers the

other cost, such as administration and servicing costs. This is a cost spread or premium.

However, BOVAG enterprises have the possibility to finance a small part of the funding itself, by

providing a subordinated loan to BFM. The amount of debt used in the funding of the contract is fixed

at 80% (in this example) of the total financed amount. The other part is financed by equity minus the

part of subordinated debt from the BOVAG enterprise. By depositing subordinated debt, the

percentage of equity used in for funding the contract is decreased. Therefore, less (expensive equity) is

used to finance the contract, which can lower the interest rate of the contract. Depending on the term

of the contract, amount of subordinated debt and the type of BOVAG enterprise, it is possible to

determine the interest rate of the contracts.

The rate is calculated as follows:

=

The interest rate premium is the rate at which the BFM can borrow its money from third parties

(currently from ING and within the group). This rate is (currently) fixed at 2%. The IRSt is the market

IRS interest rate, depending on the term (t) of the contract. Despite the fact that the IRS is a variable

rate, BFM has no influence on the rate. For example, the current rates (November) are displayed

below:

IRS

1 0,398%

2 0,506%

3 0,671%

4 0,883%

Confidential

Confidential

Page 97: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

89 Master Thesis Vincent Bakker 21-03-2014

5 1,105%

The equity requirement is the amount of equity that is required by the funder of BFM (ING) to receive

a 2% + IRS rate. This is fixed at 20%. So the first term

is the cost of debt in the contract funding (this

is ).

The %Equity is the percentage of equity from BFM that is used to finance the contract. The general

assumption is that 80% of debt is used to finance the contract. The other 20% is either equity or

subordinated debt. The RoE is the required return on equity (EBIT). This is fixed at 11%.

So the second term is the cost of equity in the contract funding (this is

).

However, the BOVAG enterprise has the ability to deposit a subordinated loan to the finance

company. The % Subordinated debt is the percentage of subordinated debt that is placed by the

BOVAG enterprise. They receive the same debt rate over the subordinated debt as the interest rate of

contract. Therewith, they can finance a small part of the contract itself. The height of subordinated

debt can be chosen by the BOVAG enterprise in pieces of 5% from 0% to 20%. This leads to the

following distribution of subordinated debt and equity.

So the cost of debt and equity have to be calculated over the part that is financed by equity or debt

form BFM. The term ensures the percentage of subordinated debt is taken

into account.

The third component is the cost spread or premium and is the interest rate premium to cover the costs

of establishing and servicing the contracts. These are depending on the term (t) and customer type (i)

This enables us to derive an interest rate of a contract, for a certain customer type, contract term and

percentage of subordinated debt.

Subordinated debt 0% 5% 10% 15% 20%

Equity BFM 20% 15% 10% 5% 0%

Cost spread

Mange

ment &

funding

Label

lease

Funding

only

1 0,80% 1,00% 0,50%

2 0,80% 0,90% 0,40%

3 0,80% 0,80% 0,30%

4 0,70% 0,80% 0,30%

5 0,60% 0,80% 0,30%

Confidential

Page 98: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

90 Master Thesis Vincent Bakker 21-03-2014

Appendix 8: Cost estimation The cost estimation is based on experiences of experts in the field of securitization. With interviewing

some experts from and provided documents from various parties, we have determined the additional

costs of securitization in Figure 32. We have made 3 assumptions for cost that we expect to make

(column Jan/Vincent).

Figure 32: cost estimation based on expert opinions

november-13

IRS

1 0,398%

2 0,506%

3 0,671%

4 0,883%

5 1,105%

Subordinated debt 0% 5% 10% 15% 20%

1 4,5% 4,1% 3,7% 3,2% 2,7%

2 4,4% 4,1% 3,7% 3,2% 2,7%

3 4,5% 4,1% 3,7% 3,3% 2,8%

4 4,6% 4,3% 3,9% 3,5% 3,0%

5 4,8% 4,5% 4,1% 3,7% 3,2%

Subordinated debt 0% 5% 10% 15% 20%

1 5,0% 4,6% 4,2% 3,7% 3,2%

2 4,9% 4,6% 4,2% 3,7% 3,2%

3 5,0% 4,6% 4,2% 3,8% 3,3%

4 5,1% 4,8% 4,4% 4,0% 3,5%

5 5,3% 5,0% 4,6% 4,2% 3,7%

Subordinated debt 0% 5% 10% 15% 20%

1 4,8% 4,4% 4,0% 3,5% 3,0%

2 4,8% 4,5% 4,1% 3,6% 3,1%

3 5,0% 4,6% 4,2% 3,8% 3,3%

4 5,0% 4,7% 4,3% 3,9% 3,4%

5 5,1% 4,8% 4,4% 4,0% 3,5%

funding only (large customer (>200 auto's))

Management and funding

funding guidelines BFM

Label lease customer (<200 auto's)

Fixed Up-front and Fixed running costs involved in a securitization

Up-front costs Estimated cost DB ING Rabobank Jan/ Vincent

Revieuw Counsel 100.000€ 175.000€ 25.000€

Legal advise fees ( incl reporting) 375.000€ 375.000€

Accounting and tax advice 25.000€ 25.000€

Listing fees 2.500€ 2.500€

SPV and trust establishment 10.000€ 5.000€ 15.000€

Rating agent 337.500€ 500.000€ 175.000€

portfolio audits 2.000€ 2.000€

Cash manager 5.000€ 5.000€

account bank 3.000€ 3.000€

paying agent 2.000€ 2.000€

trustee 5.000€ 5.000€

Data model 50.000€ 50.000€

Total 917.000€

305.667€

Running costs/ fees (per month)

SPV administrator 10.000€ 20.000€ -€

SPV trustee 10.000€ 5.000€ 15.000€

Cash manager 5.000€ 5.000€

account bank 3.000€ 3.000€

paying agent 2.000€ 2.000€

Rating agent 10.000€ 10.000€

Underwriting 20.833€ 0,25% *volume

Total fees ( per month) 60.833€

Per year 730.000€

Confidential

Page 99: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

91 Master Thesis Vincent Bakker 21-03-2014

Appendix 9: Explanation of Excel model of cost-effective deal size

Parameters

The model is depending on a number of parameters that can be adjusted to the situation of BFM. We

have separated the parameters into 3 different types:

Parameters of bank funding

Parameters of portfolio

Parameters of securitization

Bank funding parameters explained:

“IRS”: The IRS rate is the variable debt rate (in our example we used the IRS rates of

November from http://www.ingcommercialbanking.com/eCache/NLD/27/068.html).

“Bank Opslag”: the interest rate premium on debt to be paid above the variable rate.

“Eigen inbreng eis”: the percentage of equity used for funding.

Portfolio parameters explained:

“RoE” (return on equity): the interest requirement on equity or equity cost rate.

“Portfolio volume”: the total value of car financings, this is a variable parameter to find the

cost-effective deal size.

“Looptijd”: the average contract term in years.

“Klanten verdeling”: the distribution of customers as percentage of portfolio volume.

Securitization parameters explained:

“Selectie portfolio”: the portfolio percentage to securitize.

“Senior note rates (ABCP)”: the expected senior rate on commercial paper of ABCP.

“Senior note rates (ABS)”: the expected senior rate on ABS.

In our calculations, we used the input for the bank funding parameters and portfolio parameters as

displayed in Figure 33. These correspond to the current situation of BFM. We assume that no defaults

occur. Costs are left out, because these are put through one on one to the customers and do (in theory)

not affect the results.

Figure 33: Input parameters bank funding

These parameters result in the following balance sheet and profit and loss accounts for BFM:

Parameters bank funding Parameters BFM portefeuille

IRS (years) IRS november RoE 11%

1 0,398% Max AL 20%

2 0,506% Huidig AL 0%

3 0,671% Portfolio volume 100.000.000€

4 0,883% Looptijd 3

5 1,105%

Klanten verdeling

Bank funding Grote klant 3 53%

Bank Opslag 2,10% Label klant 2 4%

Eigen inbreng eis 15% beheer klant 1 43%

Confidential

Page 100: Securitization of car financing assets: A capital raising ...essay.utwente.nl/64710/8/Bakker_MA_MB_PUBLIC.pdf · growth of the car financing asset portfolio of the finance company

92 Master Thesis Vincent Bakker 21-03-2014

Confidential